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 member firms that recommend private offerings have obligations under FINRA Rule 2111 (Suitability) and FINRA Rule 3110 (Supervision) to conduct reasonable diligence by evaluating, at a minimum, “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. Among other things, Reg BI requires that a broker-dealer exercise reasonable diligence, care and skill to understand the potential risks and rewards associated with the recommendation, and have a reasonable basis to believe that the recommendation could be in the best interest of at least some retail customers. A broker-dealer could violate the reasonable basis portion of Reg BI’s Care Obligation by not fully understanding the recommended security, even if the security could have been in the best interest of at least some retail customers.
Additionally, FINRA Rules 5122 (Private Placements of Securities Issued by Members) and 5123 (Private Placements of Securities) require member firms to timely file offering documents and information for the private placement offerings they sell, including retail communications that promote or recommend an offering, with FINRA’s Corporate Financing Department, unless there is an available exemption.
- Does your firm have policies and procedures reasonably designed to achieve compliance with Reg BI when making recommendations of private placements to retail customers?
- Do your firm’s promotional communications for its private placements balance the potential benefits of the investment with a disclosure of the potential risks, such as the potential for private placement investments to lose value, their lack of liquidity and their speculative nature?
- 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 investigations prior to recommending private placement offerings, including conducting further inquiry into red flags?
- How does your firm address conflicts of interest identified during the reasonable investigation process and in third-party due diligence reports?
- How does your firm manage contingency offerings, including the transmission of funds, review of the contingency terms and determination of the appropriate steps upon any amendments to the terms of the contingency, in order to ensure compliance with Exchange Act Rules 10b-9 and 15c2-4, as applicable?
Findings and Effective Practices
- Late Filings: Not maintaining 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’s first date of sale).
- Lack of Reasonable Basis: Failing to conduct a reasonable investigation 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 there is a lack of operating history;
- relying solely on the firm’s past experience and knowledge with an issuer based on previously completed offerings;
- failing to inquire into, analyze and resolve red flags identified during the reasonable investigation process or in third-party due diligence reports;
- failing to maintain records of or otherwise evidence or reasonably explain the firm’s due diligence efforts into the accounting procedures, operations, historical performance and financial condition of the issuer, questionable representations by the issuer or litigation involving the issuer;
- failing to monitor and supervise the escrow process in connection with contingency offerings, including not ensuring funds are deposited in an appropriate escrow or segregated account prior to being released to the issuer, or failing to return funds to subscribers when contingencies are not met or when the minimum offering amount is amended; and
- failing to adopt adequate procedures to address all aspects of the firm’s private placement business, failing to adhere to the firm’s WSPs or both.
- Private Placement Checklist: Creating reasonably designed checklists with—or adding to existing due diligence checklists—articulated processes, requirements for filing and related documentation, assignment of staff responsible for performing functions and tasks, and evidence of supervisory principal approval for the reasonable investigation process.
- Independent Research: Conducting and documenting independent research on material aspects of the offering; verifying representations and claims made by the issuer that are crucial to the performance of the offering (e.g., unrealistic costs projected to execute the business plan, coupled with unsupported projected timing and overall rate of return for investors); 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.
- Identifying Conflicts of Interest: Identifying 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 Investigation and Compliance: Assigning responsibility for private placement reasonable investigation 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: When reasonable, conducting reviews after the offering closes to ascertain whether offering proceeds were used in a manner consistent with the offering memorandum and maintain supporting records of the firm’s reasonable investigation efforts.
- Private Placements Topic Page
- Corporate Financing Private Placement Filing System User Guide
- FAQs about Private Placements
- Regulation Best Interest Key Topics Page
- Report Center – Corporate Financing Report Cards
- 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)
Communications with the Public