Regulatory Obligations and Related Considerations
In Regulatory Notice 10-22 (Obligations of Broker-Dealers to Conduct Reasonable Investigations in Regulation D Offerings), FINRA noted that members that recommend private offerings have obligations under FINRA Rule 2111 (Suitability) and FINRA Rule 3110 (Supervision) to conduct reasonable diligence 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.” Although FINRA’s Suitability Rule continues to apply to recommendations to non-retail customers, it no longer applies to recommendations to retail customers. Instead, the SEC’s Reg BI applies to recommendations to retail customers of any securities transaction or investment strategy involving securities, including recommendations of private offerings.
Additionally, 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), and should also be aware of recent amendments to these rules.12
- 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 confirm that associated persons conduct reasonable diligence prior to recommending private placement offerings, including conducting further inquiry into red flags?
- How does your firm address red flags regarding conflicts of interest identified during the reasonable diligence process and in third-party due diligence reports?
- How does your firm manage the transmission of funds and amended terms in contingency offerings, including ensuring compliance with Securities Exchange Act Rules 10b-9 and 15c2-4, as applicable?
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 12 months after the offering closing date).
- No Reasonable Diligence – Failing to perform reasonable diligence of private placement offerings prior to recommending them to retail investors, including:
- failing to conduct an appropriate level of research, particularly when the firm lacks experience or specialized knowledge pertaining to an issuer’s underlying business or when an issuer lacks an operating history;
- relying unreasonably on the firm’s experience with the same issuer in previous offerings; and
- failing to inquire into and analyze red flags identified during the reasonable-diligence process or in third-party due diligence reports.
- Private Placement Checklist – Creating checklists with—or adding to existing due diligence checklists—all steps, filing dates and related documentation requirements, noting staff responsible for performing functions and tasks and evidence of supervisory principal approval for the reasonable diligence process and 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 deemed material to a potential investor (such as liquidity restrictions).
- Independent Verification – Verifying information that is 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), in some cases with support from law firms, experts and other third-party vendors.
- Identifying Conflicts of Interest – Using firms’ reasonable diligence processes to identify conflicts of interest (e.g., firm affiliates or issuers whose control persons were also employed by the firm) and then addressing such conflicts (such as by confirming that the issuer prominently and comprehensively discloses these conflicts in offering documents or mitigating them by removing financial incentives to recommend a private offering over other more appropriate investments).
- Responsibility for Reasonable Diligence and Compliance – Assigning responsibility for private placement reasonable diligence and compliance with filing requirements to specific individual(s) or team(s) and conducting targeted, in-depth training about the firms’ policies, process and filing requirements.
- Alert System – Creating a system that alerts responsible individual(s) and supervisory principal(s) about upcoming and missed filing deadlines.
- Post-Closing Assessment – Conducting reviews after the offering closes to ascertain whether offering proceeds were used in a manner consistent with the offering memorandum.
- Regulatory Notice 21-26 (FINRA Amends Rules 5122 and 5123 Filing Requirements to Include Retail Communications That Promote or Recommend Private Placements)
- Regulatory Notice 21-10 (FINRA Updates Private Placement Filer Form Pursuant to FINRA Rules 5122 and 5123)
- 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
Conservation Donation Transactions Risks
FINRA is seeing continued syndications of Conservation Donation Transactions (CDTs) investment programs among broker-dealers. CDTs commonly involve private placement offerings where investor returns are based on a share of tax savings from a charitable donation. In practice, CDTs involve unrelated investors acquiring an interest in a passthrough entity (i.e., a partnership or limited liability company) owning unimproved land. Before year-end, the passthrough entity either grants a conservation easement—which forever limits future development of the land—or outright donates the land to a land trust. In exchange, the passthrough entity receives charitable donation tax deductions, which serve as a return on investment to investors and often have values based solely on land appraisals that are predicated on an alternative plan to develop the land, oftentimes the equivalent of four to more than 10 times the price paid to acquire the land. (Common CDTs involve syndicated conservation easement transactions (SCETs) or substantially similar, fee simple donations of land.)
Firms that engage in CDTs should consider the following questions to determine whether they meet regulatory obligations:
- Do the CDT sponsor, appraiser or other related service providers have any prior, adverse audit history?
- Do your firm’s offering disclosures present potential conflicts of interest among sponsors, consultants, land developers, prior landowners, broker-dealers, and registered persons having employment or affiliated relationships?
- In compliance with Reg BI, does your firm:
- consider reasonably available alternatives to any recommendation of CDTs (i.e., the Care Obligation);
- have policies and procedures to identify and—at a minimum—disclose or eliminate all conflicts of interest associated with the recommendation (i.e., the Conflicts of Interest Obligation); and
- have policies and procedures to identify and mitigate any conflicts of interest associated with recommendations of CDTs that create an incentive for an associated person to place the interest of the firm or the associated person ahead of the retail customer’s interest?
- In compliance with SEA Rule 15c2-4, does your firm promptly transmit funds to either an escrow agent or a separate bank account (as CDTs are typically associated with contingent offerings)?
- How does your firm establish and document reasonable diligence of CDTs, including further inquiries in the presence of red flags (e.g., CDTs resulting in donation deductions that are more than two-and-one-half times an investor’s investment, concerns surfaced in third-party due diligence reports, large markups associated with land acquisition, certain types of fees to related parties, marketing communications promoting CDTs solely on their tax benefits)?
For additional guidance, please refer to these resources:
- FINRA, 2018 Report on Examination Findings – Reasonable Diligence for Private Placements (Dec. 7, 2018)
- United States Senate, Report on Syndicated Conservation-Easement Transactions
- Internal Revenue Service, IRS increases enforcement action on Syndicated Conservation Easements (Nov. 12, 2019)
- Internal Revenue Service, IRS concludes “Dirty Dozen” list of tax scams for 2019: Agency encourages taxpayers to remain vigilant year-round (Mar. 20, 2019)
- Land Trust Alliance, Important Advisory: Tax Shelter Abuse of Conservation Donations (Feb. 1, 2018)
- Internal Revenue Service, Notice 2017-10, Listing Notice – Syndicated Conservation Easement Transactions
12 Regulatory Notice 21-10 summarized the recent updates to the 5122/5123 Notification Filing Form that became effective on May 22, 2021, and Regulatory Notice 21-26 announced that, as of October 1, 2021, FINRA Rules 5122 and 5123 require member firms to file retail communications that promote or recommend a private placement offering that is subject to these rules’ filing requirements with FINRA’s Corporate Financing Department.