Securities Regulator Reminds Financial Services Firms of Their Obligations With Respect to Private Placement Recommendations

By James Eccleston

iting "significant problems in several recent examinations and investigations", FINRA (the Financial Industry Regulatory Authority) has issued Regulatory Notice 10-22 to warn firms of their obligations in what has become a $609 billion market for private placement securities. The lengthy notice addresses several areas, including the general regulatory responsibilities of financial services firms which I will address in this article.

Preliminarily, Regulatory Notice 10-22 outlines the offering requirements of what is formally known as "Regulation D" under the Securities Act of 1933. Regulation D allows issuers to be exempt from the registration requirements of the federal securities laws assuming that certain conditions are met. However, no issuers ever are exempt from the antifraud provisions of the securities laws. Likewise, no financial services firms ever are exempt from their duty to conduct a reasonable investigation of the securities that they recommend, including private placement securities under Regulation D.

Under the antifraud provisions of the securities laws as well as FINRA rules, financial services firms have a duty to conduct a reasonable investigation of both the security and the issuer's representations about the security. Regulatory Notice 10-22 states that the "amount and nature" of the investigation depends upon several factors, including "the nature of the recommendation, the role of the broker in the transaction, its knowledge of and relationship to the issuer, and the size and stability of the issuer." Certainly, a "more thorough investigation" is required for securities issued by smaller companies of recent origin. Similarly, the presence of any "red flags" also would alert the firm to the "need for further inquiry."

Importantly, a firm that "lacks essential information about an issuer or its securities" when it makes a recommendation "must disclose this fact as well as the risks that arise from its lack of information." FINRA reminds firms that they "may not rely blindly upon the issuer for information concerning a company." Indeed, firms cannot rely upon the issuer or upon the issuer's counsel in lieu of conducting their own reasonable investigation.

Critically, in their investigations firms must exercise a "high degree of care." Firms must "independently verify an issuer's representations and claims." If the offering is a "speculative venture", firms "must be particularly careful in verifying the issuer's obviously self-serving statements." The regulatory notice further states that the firm's duty to investigate is not obviated by the fact that the firm's customers (that is, the purchasers of the private placement) are sophisticated and knowledgeable.

Before recommending a security (such as a private placement) to a customer, a financial services firm and its advisers must comply with FINRA Rule 2310 (the suitability rule). The rule has two parts. "Reasonable basis" suitability requires the firm to believe that the security is suitable for at least some of its customers. Additionally, "customer specific suitability" requires the firm and its adviser to believe that the security is suitable for the particular customer. The regulatory notice reminds firms that a customer's ability to meet the net worth or income test for accredited investor status is only one suitability factor to be considered "in the course of a complete suitability analysis." Notably, FINRA reminds firms that the suitability duty requires firms to be satisfied that the customer "fully understands the risks involved and is…able…to take those risks."

In connection with the suitability of private placement recommendations, FINRA expects firms, at a minimum, to conduct a reasonable investigation concerning:

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

Notably, this investigation must be in connection with each private placement offering, notwithstanding the fact that the subsequent offering may be for the same issuer.

Regulatory Notice 10-22 next addresses specific issues related to the responsibilities of a financial services firm. First, what happens when the financial services firm is affiliated with the issuer? FINRA responds by stating that the financial services firm must not allow its affiliation to compromise its independence as it performs its investigation. Any conflict of interest that could impair the firm's ability to properly investigate must be resolved.

Likewise, sometimes the financial services firm prepares the private placement memorandum, a document that describes the offering to prospective purchasers. How does that alter its duties? FINRA responds by stating that the firm has a duty to investigate the securities offered as well as the representations made by the issuer in the private placement memorandum. FINRA considers such a document to be a "communication with the public", and as such, the document must be fair, balanced, and not misleading. Likewise, any sales literature concerning a private placement which the firm distributes generally is considered to be a communication with the public. Firms thus must ensure that such sales literature is fair, balanced and not misleading, whether or not they assisted in its preparation.

Finally, what happens when firms discover 'red flags" during their investigation? FINRA responds by stating that firms must note and follow up on any such information, including "to investigate any substantial adverse information about the issuer." Put another way, when presented with red flags, firms "must do more than simply rely upon representations by issuer's management, the disclosure in an offering document or even a due diligence report of issuer's counsel." Importantly, should an issuer refuse to provide the firm with information that is necessary for the firm to meet its duty to investigate, that fact alone could constitute a red flag.

As one can see, Regulatory Notice 10-22 places a substantial burden on financial services firms to do their homework before recommending private placements to their customers. That's good news!

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About the Author:
James J. Eccleston is the president of Eccleston Law Offices, P.C. The Chicago-based firm represents investors and advisers nationwide in securities and employment matters. 312-332-0000 www.EcclestonLaw.com.