January 21, 2011 Comments (0) Blog, Securities Fraud

FINRA Rules on Private Placements

(Last Updated On: July 17, 2015)

Private Placements have become a hot button issue for FINRA regulators and securities attorneys representing investors.  The number of private placement cases has spiked considerably over the past few years in large part because of the sizable commissions brokerage firms generate from selling private placements.  We are currently handling numerous cases involving private placement investments that went under like DBSI, Medical Capital, and Provident Royalties (among others).

New rules have been implemented requiring full disclosure of these commissions, and even more rules are being contemplated.  The following is a brief overview of those FINRA Rules, as well as some of the relevant case law that discusses a brokerage firms obligation to perform due diligence on a private placement investment prior to recommending it to any of its clients.

The first significant rule that applies in private placement fraud cases is NASD Rule 2310.  NASD Rule 2310 states that a brokerage firm must have a reasonable grounds to believe that a customer recommendation to purchase, sell or exchange a security (including a private placement investment) is suitable for the customer. See, also FINRA Notice to Member 03-71 concerning non-conventional investments and Notice to Member 05-18 concerning private placements of tenants-in-common interests.

This suitability analysis has two principal components.  First, the “reasonable basis” suitability analysis requires the brokerage firm to have a reasonable basis to believe, based on a reasonable investigation, that the recommendation is suitable for at least some investors.  This is where certain private placements, such as Medical Capital, DBSI, and Provident, fail the suitability test.  Had brokerage firms perform the proper amount of due diligence on these investments, the firms would have realized that ponzi schemes are obviously not appropriate investments for any investors.

The second prong, is the “customer specific suitability analysis, which requires that the brokerage firm determine whether the security is suitable for the customer to whom it would be recommended.  This is often referred to as the Know Your Customer Rule, but in essence, brokerage firms are required to account for a client’s age, investment experience, net worth, and investment goals in determining whether an investment is appropriate for a particular client.  Private placements often fail the suitability test for this reason.  Private placements, by there very nature, are often risky investments, which are virtually never appropriate for conservative or retired investors.

In addition to determining suitability, brokerage firms have a high due diligence requirement.  Specifically, brokerage firms are charged with exercising a high degree of case in investigating and independently verifying an issuer’s representations and claims.  Additionally, when an issuer is seeking to finance a new speculative venture, a broker dealer can not blindly rely on the issuer’s representations and are required to be particularly careful in this instance and must verify the issuer’s obviously self-serving statements.

A brokerage firm has an even greater responsibility to perform due diligence on a specific investment if the firm is deemed to be affiliated in some way with the issuer.  This can occur if the brokerage firm assists the company in preparing the private placement memorandum or if there are red flags present.

Finally, brokerage firms are required to follow NASD Rule 3010 and to ensure that the firm’s personnel, including its registered representatives, comply with their legal and regulatory requirements.

Much of the foregoing is discussed in FINRA Regulatory Notice 10-22 on Regulation D offerings.

Brokerage firms are also required to follow FINRA Rule 5122 when dealing with private placements.  FINRA Rule 5122 was developed in response to abuses in the sale of private placements issued by broker-dealers and their control entities.  The Rule generally requires that a member firm or associated person (financial advisor) engaging in a private placement of unregistered securities issued by the firm:

(1)   disclose to investors in a private placement memorandum, term sheet or other offering document the intended use of offering proceeds, the offering expenses and the amount of compensation that will be paid to the broker-dealer and its associated persons;

(2)  submit the offering documents to the FINRA Corporate Financing Department; and

(3)  comply with the requirement that at least 85% of the offering proceeds raised may not be used to pay for offering costs, discounts, commissions or any other cash or non-cash incentives.

Obviously, the big one here is the disclosure of the commission paid.  In many cases we have handled, the commission is either not disclosed or is disclosed in such a way that an unsophisticated investor cannot determine the commission paid to the brokerage firm making the representation.  Private placements often pay a commission far in excess of other traditional types of investments (sometimes as high as 8-10%) and investors would certainly be more concerned about making such an investment if they knew that the broker was being paid this commission.

For more information on FINRA Rule 5122 look at FINRA Regulatory Notice 11-04.

If you have additional questions about private placements or are concerned about a private placement investment you made through a brokerage firm, the securities attorneys of The White Law Group may be able to help.  For a free consultation, please call the firm’s Chicago office at 312-238-9650.

The White Law Group, LLC is a national securities fraud, securities arbitration, investor protection, and securities regulation/compliance law firm with offices in Chicago, Illinois and Boca Raton, Florida. With over 30 years of securities law experience, including experience working at FINRA (f/k/a the NASD) and the SEC, The White Law Group has the expertise to help investors defrauded in securities, investment and financial business transactions.

For more information on The White Law Group, please visit our website at http://www.whitesecuritieslaw.com.

-->