Today’s current economic marketplace is dynamic. Particularly when volatility peeks in the financial markets, investors and asset managers seek new opportunities for diversification. Thus, alternative investments are an increasingly important part of an investment portfolio.
Private placements allow for private investment opportunities not available through the public markets. Offered to a limited number of investors, private placements are exempt from federal securities registration requirements, but are regulated by the U.S. Securities and Exchange Commission (“SEC”) under Regulation D. This requires the issuer of the private placement to provide sufficient information to investors to avoid violating the antifraud provisions of U.S. securities laws.
Because private placements are not required to be registered, and are, by definition, illiquid in nature, they generally are viewed as a higher-risk investment. For this reason, in recent years, both the SEC and the Financial Industry Regulatory Authority (“FINRA”) have proposed and/or approved certain rules to help protect investors. While advisers may not be associated with a broker-dealer and therefore subject to FINRA regulations, it is nevertheless noteworthy to keep in mind this guidance, which could serve as best practices for advisors to consider when developing compliance controls. Moreover, as these regulatory requirements impact managing broker-dealers, so too must those broker-dealers evolve the way they interface with advisers and the adviser’s clientele.
In this article, we will explore regulatory considerations for offering private placements to investors. Specifically, we will consider those broker-dealer regulations which govern private placement offerings and consider the impact that FINRA Regulatory Notice 10-22 (Obligations of Broker-Dealers to Conduct Reasonable Investigations in Regulation D Offerings), SEC’s Regulation Best Interest (“Reg BI”) and FINRA Rules 5122 (Private Placements of Securities Issued by Members) and 5123 (Private Placement of Securities), as amended, have on compliance programs. Based on such guidance, we will consider certain internal control practices that investment advisers may wish to consider when offering private placements to their clients.
Broker-Dealer Private Placement Regulations
In February 2022, FINRA issued its 2022 Report on FINRA’s Examination and Risk Monitoring Program. (the “2022 Report”). Presented as a reference guide, the 2022 Report provides key considerations for broker-dealers to consider when structuring and reviewing the member firm’s compliance program.
A. Going Back to the Basics – Refer to the Guidance in Regulatory Notice 10-22
FINRA member firms have a duty to conduct a reasonable investigation of any security it recommends, which includes private placement offerings. Specifically, the member firm must evaluate the merits and risks of the investment with the suitability, and now, best interest considerations of its customers.
When evaluating a private placement, the broker-dealer must conduct a “reasonable investigation” concerning the security and the issuer’s representations about the offering. Should the broker-dealer not fulfill this obligation, the member firm could be found to be in violation of FINRA Rule 2010 (for failure to adhere to just and equitable principles of trade) and the various antifraud provisions of federal securities laws (such as Section 10(b) and Rule 10b-5 of the Securities Exchange Act). While conducting the investigation, should a “red flag” be found, additional due diligence is required. The amount of due diligence will be based upon the facts and circumstances of the offering, including the source of the information and the broker-dealer’s relationship with the issuer. For example, a “high degree of care” should be used whenever investigating and verifying an issuer’s representations. If the broker-dealer is unable to obtain important information, this fact may trigger additional disclosures from the broker-dealer to its customers about the risks that arise from this lack of information. This is required in light of the antifraud provisions to which broker-dealers are subject.
Should a “red flag” be found, additional due diligence is required. If the broker-dealer is unable to obtain important information, this fact may trigger additional disclosures from the broker-dealer to its customers about the risks that arise from this lack of information. This is required in light of the antifraud provisions to which broker-dealers are subject.
The scope of the investigation also is dependent upon the broker-dealer’s role in the offering, whom the alternative investment is being offered (i.e., retail or institutional investors) and affiliation with the issuer (including mitigation and disclosure of conflicts of interest). As a means to memorialize efforts taken to conduct a “reasonable investigation,” FINRA suggests documenting the due diligence process undertaken, maintain meeting minutes of conversations undertaken with the issuer and other relevant parties, keep notes of findings, red flags, documents reviewed and the dates of such reviews, list the individuals involved in the review and summarize conclusions and recommendations.
In its 2022 Report, FINRA cautioned that as part of its exam findings, member firms have neglected to perform adequate research on private placement offerings, and have not considered the history of the issuer, past financial discrepancies, and other red flags. Below are some of the subject matter areas to inquire about as part of a member firm’s due diligence efforts.
- Examine issuer governance documents noting restrictions on activities;
- Examine financial statements and consider if they have been audited by an independent certified public accountant;
- Ask for organization charts and information about affiliates and any conflicts of interest;
- Ask about pending legal procedures and disciplinary history of the principals or the issuer;
- Consider the issuer’s experience and past offerings;
- Request financial models and backup supporting forecasted projections;
- Physically inspect the issuer’s facilities and assets, land, project, etc., as appropriate
Regulation BI and Suitability Concerns
As of June 2020, broker-dealers must consider Reg BI whenever dealing with natural persons. This includes private placements that are offered to retail customers, which is broadly defined. Should the retail customer receive a recommendation to transact in a private placement, then Regulation BI is triggered. This standard of conduct requires more than just a suitability consideration for consumers. Rather, the member firm must act in the best interest of the retail customer at the time the recommendation is made, without considering the interests of the broker-dealer. Moreover, the member firm must establish and enforce supervisory procedures which address conflicts of interest including the disclosure of such conflicts and mitigation or elimination thereof. This requires the member firm to consider the policies and procedures it has in place for offering private placements to natural persons (which is governed by Regulation BI) and non-retail clients (which are governed by FINRA Rule 2111 (Suitability).
Thus, member firms should develop a compliance program considering whether the private placement investment opportunity is in the best interest of or suitable for the customer. In coming to this conclusion, the member firm should consider not only the due diligence findings of the offering but also the specific customer needs at the time of the recommendation, taking into account the customer’s investment goals and needs, net worth, sophistication, tax status, investment objectives, other holdings, risk tolerance, and other factors. Should Reg BI apply, the broker-dealer also must consider its disclosure obligations about conflicts of interest related to the member firm’s relationship with the issuer, including compensation arrangements and its compliance obligations to establish, maintain and enforce policies and procedures to achieve compliance with Reg BI.
The member firm must act in the best interest of the retail customer at the time the recommendation is made, without considering the interests of the broker-dealer. Moreover, the member firm must establish and enforce supervisory procedures which address conflicts of interest including the disclosure of such conflicts and mitigation or elimination thereof.
Reminders about Filing Requirements and Timelines Under FINRA Rules 5122 and 5123
FINRA Rule 5122 governs the private placement of securities issued by member firms. The Rule requires each member firm offering or selling securities in a private placement to file a copy of any private placement memorandum, term sheet, other offering documents, or retail communication that recommends the member private offering (collectively, “offering documents”) with FINRA’s Corporate Financing Department at or prior to the first time the document or retail communication is provided to any prospective investor. Amendments to any offering documents must also be filed with FINRA within 10 days of being provided to any investor or prospective investor. The rule exempts certain limited offerings sold solely to institutional, qualified and other sophisticated purchasers.
In addition, Rule 5122 requires the member firm to deliver to the prospective investor disclosures related to the intended use of the offering proceeds as well as the offering expenses and amount of selling compensation that will be paid to the member firm and its associated persons. If this information is not referenced in the offering documents, the member firm must supply these disclosures to the prospective investor.
Finally, Rule 5122 generally requires issuer member firms engaging in private placements of unregistered securities to disclose in the offering documents the intended use of the proceeds, offering expenses, and the amount of selling compensation to be paid to the broker-dealer. Notably, at least 85% of the offering proceeds raised must be used for business purposes and not be used to pay for offering costs, discounts, commissions, or any other cash or non-cash incentives. In the event that this condition is not met, upon discovery, the member firm must promptly comply with the Rule.
Similarly, Rule 5123 applies to each FINRA member firm selling securities in a private placement to file a copy of any private placement memorandum, term sheet, or other offering documents with FINRA, including any materially amended versions, within 15 calendar days from the date of sale (or indicate that it did not use any such offering document). The rule became effective on December 3, 2012, and applies prospectively to any private placement that begins selling efforts thereafter. The rule exempts certain limited offerings sold solely to institutional, qualified, and other sophisticated purchasers. According to FINRA’s Regulatory Notice announcing Rule 5123, both Rules 5122 and 5123 “are part of a multi-pronged approach to enhance oversight and investor protection in private placements.”
FINRA developed a private placement filing system to receive the offering documents via the Firm Gateway and that allows member firms and others to submit filings on behalf of others involved in the sale. In its latest exam findings, FINRA has noted that some member firms have not developed adequate policies and procedures, processes, and supervisory programs to comply with filing requirements, or have failed to make timely filings. Thus, existing internal controls should be evaluated.
Effective Practices for Broker-Dealers and Investment Advisers to Consider
In its 2022 Report, FINRA shared several effective practices, in addition to those listed above, that member firms should consider. This includes reviewing the following practices:
- If a red flag is identified during the due diligence process of the private placement, how is it addressed?
- What supervisory controls are in place to ensure that the firm has enough experience to conduct reasonable diligence on the issuer’s underlying business or to identify red flags?
- Has a private placement checklist been developed to capture all steps required for selling private placements, including due diligence efforts, filing dates, and supervisory reviews (including consideration for Reg BI and suitability efforts and oversight)?
- Have conflicts of interest been identified and disclosed?
- Is there a post-closing assessment to determine whether the offering proceeds used were consistent with that outlined in the offering documents?
While FINRA has focused on these requirements for its member firms, investment advisers, too, can benefit from considering the tools and practices to improve their compliance program efforts. For instance, FINRA provides a private placement checklist to all financial providers submitting a “Form New Member Application” or “Form Consulting Member Application” relating to private placement businesses, which is available at https://www.finra.org/compliance-tools/private-placement-checklist. When developing your internal controls consider Standard 9 of the checklist, which provides a checklist for written supervisory procedures. If offering a private placement investment to clients, consider beforehand:
- The firm’s scope and approach to due diligence review;
- Compensation and payments arrangements;
- Books and records maintenance and retention
- Communications used to market the offering; and
- Description of the supervisory procedures to be followed by the firm and identify who will oversee that procedure, and when.
As a fiduciary, the investment adviser must also determine whether the offering will be in the client’s best interest. Compliance should be involved early on to help determine the criteria that will be used to make this determination.
Private placements are an important part of an investor’s diversified portfolio. FINRA has provided guidance and suggestions on thoughtful steps that firms can take to ensure that they are meeting both regulatory requirements as well as acting in the best interest of investors. For investment advisers, it is important to consider this guidance when constructing and advancing their compliance programs for offering private placements to their clients. By implementing effective practices, including reasonable diligence of private placements and deliberate internal controls for satisfying both regulatory filing requirements, Regulatory BI, and suitability obligations, advisory firms will be well positioned to provide alternative investments as part of their service offering for many years to come.
Author: Michelle L. Jacko, Managing Partner of Jacko Law Group, PC (“JLG”). JLG works extensively with investment advisers, broker-dealers, investment companies, private equity and hedge funds, banks, and corporate clients on securities and corporate counsel matters. For more information, please visit https://www.jackolg.com/.
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 See “Regulation D Offerings” available at https://www.investor.gov/introduction-investing/investing-basics/glossary/regulation-d-offerings. Rules 504 and 506 provide distinct exemptions from registration.
 Available at https://www.finra.org/rules-guidance/notices/10-22.
 Available at https://www.finra.orgrules-guidance/rulebooks/finra-rules/5122.
 Available at https://www.finra.org/rules-guidance/rulebooks/finra-rules/5123.
 For the entire report, see https://www.finra.org/sites/default/files/2022-02/2022-report-finras-examination-risk-monitoring-program.pdf.
 See Hanly v. SEC, 415 F.2d 589, 595–96 (2d. Cir. 1969); SEC v. Great Lake Equities Co., 1990 U.S. Dist. LEXIS 19819 at *16–17 (E.D. Mich. 1990); SEC v. North American Research and Development Corp., 424 F.2d 63,84 (2d Cir. 1970). See also SEC v. Current Financial Services, Inc., 100 F. Supp. 2d 1, 14–15 (D.D.C. 2000); District Business Conduct Committee for District No. 4 v. Everest Securities, Inc., 1994 NASD Discip. Lexis 188 (Sept. 2, 1994), aff’d, 52 S.E.C. 958, 962–63 (Aug. 26, 1996), aff’d, 116 F. 3d 1235 (8th Cir. 1997); Securities Act Release No. 4445, 27 Fed. Reg. 1415 (Feb. 2, 1962).
 See Everest Securities, Inc. v. US, supra note 5 at 963.
 Consider also Regulatory Notice 09-05 (Guidance to Member Firms Participating in Unregistered Resales of Restricted Securities), Jan. 2009.
 See https://www.finra.org/rules-guidance/notices/10-22 for additional information.
 Regulation Best Interest: The Broker-Dealer Standard of Conduct, SEC Rel. No. 34-86031 (Jul. 12, 2019).
 For purposes of Reg BI, a “retail customer” is a natural person who receives a recommendation of any securities transaction or investment strategy involving securities from a broker, dealer, or a natural person who is an associated person of a broker or dealer, and uses the recommendation primarily for personal, family or household purposes. It extends to high-net-worth natural persons as well as trusts and family offices.
 As defined under Rule 2210, a “retail communication” is any written (including electronic) communication that is distributed or made available to more than 25 retail investors within any 30 calendar-day period. A “retail investor” means any person other than an institutional investor, regardless of whether the person has an account with a member. See https://www.finra.org/rules-guidance/rulebooks/finra-rules/2210#:~:text=(5)%20%22Retail%20communication%22,any%2030%20calendar%2Dday%20period for additional information.