FINRA today published its Report on FINRA Examination Findings and highlights private placement related concerns. In its examinations of the practices of many broker-dealers, the report notes FINRA found instances where the diligence review undertaken in connection with private placements was not sufficient in scope or depth to be considered a “reasonable investigation of the issuer and the securities.” In its Regulatory Notice 10-22 issued several years ago, FINRA noted that FINRA member firms have a suitability obligation under FINRA Rule 2111, including in connection with recommending an investment in a private placement. The notice describes the type of investigation that broker-dealers ought to conduct with respect to a private placement.
In its examinations, FINRA noted that member firms that had 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.”
The report cites examples of other problematic practices, including reliance on the firm’s prior experience with the same issuer without refreshing their diligence, reviewing the offering memorandum without more in-depth diligence, failing to verify independently material aspects of the offerings, and failing to investigate red flags identified during the reasonable diligence process, placing undue reliance on due diligence consultants, experts or other third-party vendors.