Private Placements

Regulatory Obligations and Related Considerations

Regulatory Obligations

In Regulatory Notice 23-08 (FINRA Reminds Members of Their Obligations When Selling Private Placements), FINRA noted the obligations of member firms that recommend private placements to conduct a reasonable investigation of those securities under Reg BI and FINRA Rule 2111 (Suitability), as well as other obligations that apply even in the absence of a recommendation, including FINRA Rules 2210 (Communications with the Public), 3110 (Supervision), 3280 (Private Securities Transactions of an Associated Person), 5122 (Private Placements of Securities Issued by Members) and 5123 (Private Placements of Securities).

Regulatory Notice 23-08 updates and supplements guidance published under Regulatory Notice 10-22 (Obligations of Broker-Dealers to Conduct Reasonable Investigations in Regulation D Offerings) and reiterates members’ obligation, when recommending a security, to conduct a reasonable investigation of the security 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, broker-dealers that recommend any securities transaction or investment strategy involving securities, including recommendations of private offerings, to retail customers are subject to the requirements of Reg BI. Among other things, Reg BI requires a broker-dealer to exercise reasonable diligence, care and skill in understanding 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 and 5123 require member firms to timely file with FINRA offering documents and information for the private placements they offer or sell, including retail communications used by the broker-dealer to promote or recommend an offering, unless there is an available exemption.

Related Considerations

• 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—including risks relevant to many private placements, such as:
  • their illiquid nature;
  • the lack of access to comprehensive information (with which to value the securities or a transparent market to set the market price);
  • the absence of substantial operating history; and
  • the lack of independently audited financial statements?
• 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 independently 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 and review of the contingency terms, in order to ensure compliance with Exchange Act Rules 10b-9 and 15c2-4, as applicable?
• If your firm prohibits recommending private placements offered by your firm, does it reflect this prohibition in its policies and procedures (and does your firm take steps to confirm that associated persons comply with the prohibition)?

Findings and Effective Practices

Findings

• 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).
• Failure to Comply with Reg BI’s Conflicts of Interest Obligation: Not adequately identifying, disclosing and, where required, mitigating conflicts of interest associated with recommendations of private placements.¹
• Failing to Conduct Reasonable Investigation: Failing to fulfill reasonable basis obligations prior to recommending private placements to retail investors, by:
  • failing to conduct an appropriate level of research, particularly when 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; and
  • failing to conduct a reasonable investigation of the issuer, the individuals involved in its management or other “covered persons” under Reg D.
• Failure to Evidence Due Diligence 
  • Failing to maintain records of, or otherwise evidence or reasonably explain, due diligence efforts into issuers’ financial condition, operations, representations of past performance, and involvement in litigation.

Effective Practices

• 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.
• “Bad Actor” Questionnaires: Reviewing “Bad Actor” forms or similar questionnaires at both the issuer level (e.g., Directors’ and Officers’ Questionnaires) and placement agent level (e.g., registered representative questionnaires) to support compliance with Rules 506(d) and 506(e) of Regulation D.
• 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 for 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 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.
• Review of Offering Terms: Reviewing offering terms to determine if they are reasonably structured for compliance with applicable rules (e.g., analyzing the escrow arrangements and termination provisions in contingency offerings).
• 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 maintaining supporting records of the firm’s reasonable investigation efforts.

Additional Resources

• FINRA
  • Private Placements Key Topics 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 Notices
    • Regulatory Notice 23-08 (FINRA Reminds Members of Their Obligations When Selling Private Placements)
    • 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 (Obligation of Broker-Dealers to Conduct Reasonable Investigations in Regulation D Offerings)
• SEC
  • Regulation Best Interest Guidance Page
  • Disqualification of Felons and Other "Bad Actors" from Rule 506 Offerings and Related Disclosure Requirements (September 19, 2013)