The Financial Industry Regulatory Authority (FINRA) issued a Regulatory Notice to its members (FINRA Regulatory Notice 10-22) outlining and reminding them of their regulatory responsibilities in connection with Regulation D private placement offerings. Among other things, members are required to conduct a reasonable investigation of any offering in order to satisfy suitability obligations. The Regulatory Notice outlines important issues, including the relevance of a broker-dealer firm’s relationship to the issuer and the type of investors being solicited.

A full copy of the Regulatory Notice can be viewed by clicking on this link.

FINRA reminded members:

  • The Securities and Exchange Commission (SEC) and federal courts have long held that a broker-dealer firm that recommends a security is under a duty to conduct a reasonable investigation concerning that security and the issuer’s representations.
  • In recommending the security, the broker-dealer represents to the customer “that a reasonable investigation has been made and that [its] recommendation rests on the conclusions based on such investigation.”
  • Failure to comply with this duty can constitute a violation of the antifraud provisions of the federal securities laws including Rule10b-5 and can also subject the broker-dealer to claims of violation of FINRA Rule 2010, requiring adherence to just and equitable principles of trade, and FINRA Rule 2020, prohibiting manipulative and fraudulent devices.

The Level of Due Diligence that May be Required is a “Facts and Circumstances” Determination. As stated in the Notice to Members, the amount and nature of the investigation depends upon many factors, including:

  • The role of the member firm in the transaction;
  • The nature of the issuer, whether it is a reporting company, its scope of operations, the type of business in which it is engaged, the existence (or not) of red flags and its history; and
  • The relationship between the broker-dealer firm and the issuer.

Member firms may not rely “blindly upon the issuer for information concerning a company nor may rely on the information provided by the issuer and its counsel in lieu of conducting its own reasonable investigation.” FINRA further states that the sophistication level of investors in the private placement offering does not excuse the broker-dealer firm from its obligation to conduct a reasonable investigation.

It is common for broker-dealer firms, which are part of a syndicate or selling group, to rely upon the lead placement agent or syndicate manager for undertaking due diligence. While FINRA recognizes this practice, it also warned firms that they must have a reasonable basis to believe that the syndicate manager has the expertise and absence of conflicts to undertake the inquiry and must ascertain that the syndicate manager has actually performed the investigation.

We recommend to our broker-dealer client firms that they develop a standardized due diligence process, and that the process include an analysis and review of:

  • Management of the issuer, including their background and compensation;
  • The business of the issuer and its current and future operations;
  • The terms of the securities being offered;
  • The issuer’s constitutive documents;
  • The financial condition and capital structure of the issuer;
  • Material contracts, relationships and affiliations of the issuer;
  • The intended use of proceeds from the offering; and
  • If the issuer is a reporting company, a review of the issuer’s recent public filings.

Relevant FINRA Regulations

FINRA Rule 2310 requires that a broker-dealer firm have reasonable grounds to believe that a recommendation to purchase, sell or exchange a security is suitable for the customer. This “suitability” analysis is comprised of two parts. The first is sometimes referred to as the “know your product” component and the second is the “know your customer” component. The know your product component requires that the broker-dealer firm have a reasonable basis to believe, based on a reasonable investigation, that the recommendation is suitable for at least some investors. We have long counseled our clients that the delivery by a member firm of a private placement offering memorandum is a recommendation of the security being offered. Therefore a reasonable level of due diligence regarding the issuer and the information provided in the placement memorandum and other offering documents is required of the broker-dealer firm.

The second component requires that the broker-dealer firm determine whether the proposed investment is suitable for the particular investor.1 This analysis should take into account, and be substantiated by, material in the client file (normally this can be satisfied by a combination of a detailed subscription document related to the offering and the client intake information when the account was opened). FINRA emphasized that “the fact that an investor meets the net worth or income test for being an accredited investor is only one factor to be considered in the course of a complete suitability analysis.”

FINRA has taken the position that a broker-dealer firm which prepares a private placement memorandum which contains material misstatements and omissions violates FINRA Rule 2010, which rule requires broker-dealer firms to comply with just and equitable principals of trade. In addition, it appears to be FINRA’s position that a private placement memorandum and related offering documents, which are prepared with a broker-dealer firm’s assistance, are communications with the public within FINRA Rule 2210.

Pursuant to NASD Rule 3010, member firms must also have in place adequate supervisory procedures to ensure that the firm and its personnel comply with its obligations in the context of private placement offerings. We often assist our clients with designing their written supervisory procedures to meet these obligations. In this context, we advise our clients to have written procedures which outline the type of information to be obtained from issuers, the responsibility of firm personnel and outside counsel, if any, to review the material, and the process for analyzing the offering documents and communicating comments to the issuer and its counsel.

Recommendations to Document the Suitability Investigation

FINRA requires that broker-dealers demonstrate that they have complied with FINRA’s rules by creating and retaining relevant documentation. Essentially, if documents and files do not exist and have not been maintained FINRA will at least initially take the position that there was no compliance. In the context of establishing that the obligations for investigation and suitability were satisfied, broker-dealers should maintain due diligence files which contain copies of documents reviewed, any analyses undertaken by broker-dealer staff and summaries of meetings and communications with issuers and syndicate members.

Investment Banking and Broker-Dealer Practice Group

The Haynes and Boone Investment Banking and Broker-Dealer Group combines the expertise of several practice areas to provide comprehensive legal services to our broker-dealer and investment banking clients. We represent U.S. national, international and regional investment banking firms, full service brokerage firms and broker-dealers, as well as investment adviser firms in transactional, litigation and regulatory matters. Our Broker-Dealer and Investment Banking Group utilizes a multi-disciplinary approach to address our clients’ needs.