Reasonable Diligence for Private Placements

FINRA has observed instances where some firms that have suitability obligations under FINRA Rule 2111 (Suitability) failed to conduct reasonable diligence on private placements and failed to meet their supervisory requirements under FINRA Rule 3110 (Supervision). FINRA Regulatory Notice 10-22 describes the circumstances under which firms have an obligation to 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.”

FINRA has observed that firms that performed reasonable diligence conducted meaningful, independent research on material aspects of the offering; identified any red flags with the offering or the issuer; and addressed and resolved concerns that would be relevant to a potential investor. Depending on their size, firms’ diligence processes included creating a due diligence committee (at larger firms) or otherwise formally designating one or more qualified persons (at smaller firms), and charging them with investigating and determining whether to approve the offering for sale to investors. As part of their process, firms independently verified information that was key to the performance of the offering, and some received support from due diligence firms, experts and third-party vendors.

Further, in offerings involving issuers that were affiliates of the firm or whose control persons were also employed by the firm, firms used the reasonable diligence process to mitigate conflicts of interest, ensured that the offerings were suitable for investors in spite of such conflicts of interest, and developed comprehensive disclosures. Firms also used insights from the diligence analysis to establish post-approval processes and investment limits based on the complexity or risk level of the offering. After the offering, firms conducted ongoing diligence to ascertain whether offering proceeds were used in a manner consistent with the offering memorandum, particularly when the firms engaged in ongoing sales of an offering after initial closing.

FINRA reminds firms conducting diligence required by the reasonable-basis suitability obligations to document both the “process and results” of such reasonable diligence analysis.¹⁴ Although firms may use a risk-based approach to documenting compliance with the suitability rule,¹⁵ even when using such an approach, firms ordinarily would be expected to document their diligence efforts regarding recommendations of private placements.

Selected Examination Findings

FINRA has observed instances where some firms’ reasonable diligence was not sufficient in scope or depth to be considered a “reasonable investigation of the issuer and the securities.”

• No Reasonable Diligence – Some firms failed to perform reasonable diligence on private placement offerings prior to recommending the offerings to retail investors. In some instances, firms performed no additional research about new offerings because they relied on their experience with the same issuer in previous offerings. In other instances, some firms reviewed the offering memorandum and other relevant offering documentation, but did not discuss the offering in greater detail with the issuer or independently verify, research or analyze material aspects of the offerings. FINRA also observed that some firms did not investigate red flags identified during the reasonable diligence process. For example, in offerings involving conservation tax easements,¹⁶ some firms did not investigate red flags that included, but were not limited to, significant risk of the Internal Revenue Service (IRS) disallowing tax deductions, as well as concerns regarding land appraisals.
• Overreliance on Third Parties – Where some firms obtained and reviewed due diligence reports provided by due diligence consultants, experts or other third-party vendors, they sometimes did not independently evaluate the third parties’ conclusions, respond to red flags or significant concerns noted in the reports, or address concerns regarding the issuer or the offering that were apparent outside the context of the report.
• Potentially Conflicted Third-Party Due Diligence – Some firms used third-party due diligence reports that issuers paid for or provided in their due diligence analysis. While some of these reports provided valuable and relatively objective information, in some cases, firms did not consider the related conflicts of interest in their evaluation and assessment of the reports’ conclusions and recommendations.

End Notes