Private Placements

Regulatory Obligations

In Regulatory Notice 23-08 (FINRA Reminds Members of Their Obligations When Selling Private Placements), FINRA noted the obligations of firms that recommend private placements to conduct a reasonable investigation of those securities under Reg BI for recommendations to retail customers and FINRA Rule 2111 (Suitability) for recommendations to non-retail customers, as well as other obligations that could 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 (FINRA Reminds Members of Their Obligations When Selling Private Placements) updated and supplemented guidance published under Regulatory Notice 10-22 (Obligations of Broker-Dealers to Conduct Reasonable Investigations in Regulation D Offerings) and reiterated firms’ 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.” 

Additionally, FINRA Rules 5122 and 5123 require 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.

Findings and Effective Practices

Findings

  • Inadequate Filings Procedures: Not maintaining policies and procedures, processes and supervisory programs to comply with filing requirements; resulting in a failure to file or untimely filings (with, in some cases, delays lasting as long as six to 12 months after the offering’s first date of sale); and misapplying filing exemptions under FINRA Rule 5123(b) (e.g., misunderstanding the accredited investor exemption under this Rule, and thus not making required filings for some offerings sold to accredited investors).
  • Failure to Comply with Reg BI’s Conflict 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.
  • Failure to Comply with Reg BI’s Care Obligation: Incorrectly purporting to not make recommendations of private placements, or claiming that the issuer is making the recommendations, despite firms’ representatives engaging in communications with customers that include a “call to action” concerning the particular security and that are individually tailored to the customer. As a result, the representative did not exercise reasonable diligence, care and skill in making such recommendations.
  • Failure to Comply with SEC Rules Regarding Contingency Offerings: Participating in a contingency offering without meeting the requirements of SEA Rules 10b-9 and 15c2-4, in particular when the contingency terms are amended during the offering (e.g., significantly reducing the minimum contingency amount). 

Emerging Trend: Private Placements Offerings of Pre-IPO Securities

  • FINRA has observed that certain parties involved in private placements focused on pre-IPO shares have engaged in potentially fraudulent activity. Specifically, FINRA has observed instances in which firms have made material misrepresentations and omitted material information in connection with the recommendations of private placement offerings of pre-IPO securities (e.g., not disclosing potential selling compensation).
  • FINRA has also observed that firms have often failed to conduct reasonable due diligence and failed to confirm or obtain sufficient documentation that the issuer actually held or had access to the shares it purported to sell. 
  • For additional guidance—including best practices for establishing and supervising a reasonable investigation process—please see Regulatory Notice 23-08. 

Effective Practices

  • Private Placement Checklist: Amending due diligence checklists to account for specific types of private placements with unique risk factors or conditions that may impact whether they are in the best interest of retail customers. 
  • “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 by, for example; 
    • verifying representations and claims made by the issuer that are crucial to the performance of the offering (e.g., costs projected to execute the business plan, 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.
  • 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).
  • Ongoing Use of Proceeds Assessment: Upon reasonably learning of material changes to the offering—or the issuer’s business during the offering—evaluating factors that may alter the issuer’s intended use of proceeds. 
  • Training: Requiring that firms’ representatives complete targeted, in-depth training about the firms’ policies, process and filing requirements prior to recommending an offering. 

Additional Resources

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Annuities Securities Products

1 See the Report’s Reg BI and Form CRS topic for additional findings concerning failure to comply with Reg BI’s Conflicts of Interest Obligation.