FINRA Issues Regulatory Notice on Broker-Dealer Responsibilities in Private Placements

On May 9, 2023, the Financial Industry Regulatory Authority (FINRA) issued Regulatory Notice 23-08 (Notice) to remind broker-dealer of their obligations when selling private placements pursuant to Regulation D safe harbors under Sections 3 and 4 of the Securities Act of 1933 (Reg D). FINRA previously addressed such obligations in Regulatory Notice 10-22, issued more than a decade ago. The Notice updates and supplements FINRA’s prior guidance and focuses on, among other things, a member’s role when recommending private placements and the application of Regulation Best Interest (Reg BI).

Recommendations in Connection With Private Placements

When recommending private placements to retail customers, broker-dealers must act in the customer’s best interest and comply with several obligations found in Reg BI. When recommending private placements to nonretail customers, broker-dealers must comply with the suitability obligation set forth in FINRA Rule 2111 (Rule 2111).¹

Reasonable Basis Obligations and Duty to Conduct a Reasonable Investigation

Both Reg BI and Rule 2111 require broker-dealers to have a reasonable basis for their private placement recommendations, which requires performing reasonable diligence to understand the nature of the security, potential risks and rewards, and suitability for at least some customers.

As previously explained by FINRA in Regulatory Notice 10-22, at a minimum, broker-dealers should conduct a reasonable investigation concerning the issuer and its management, the issuer’s business prospects, the assets held by or to be acquired by the issuer, the claims being made, and the intended use of the offering. In addition to the foregoing, in this new Notice FINRA states that member firms should consider the following areas as a part of a reasonable investigation of a private placement:

1. regulatory and litigation history of the issuer and its management (e.g., criminal, disciplinary, and litigation history), and any affiliate that may be materially involved in the issuer’s businesses, as well as the issuer’s compliance with the bad-actor provisions under Rule 506(d)-(e)
2. new material developments, including events that are or should be reasonably known to the member firm during an offering (e.g., legal proceedings or regulatory inquiries involving the issuer)
3. transactions or payments between issuers and their affiliates involving offering proceeds
4. representations of past performance of the issuer, its sponsor, or its manager to identify any such representations that may be misleading or exclusively selected based on positive results or cherry-picking

While the Notice acknowledges that firms will not have the same knowledge as the issuer or management team, FINRA states that firms should undertake a reasonable investigation that independently verifies an issuer’s material representations and claims, particularly when the member or its associated persons are affiliated with the issuer or when red flags are present.

The Notice states that a firm may show that it has conducted a reasonable and independent investigation by (i) documenting the research and analysis the broker-dealer conducted, (ii) obtaining additional information from an issuer to perform an independent analysis of issuer representations, and (iii) critically analyzing third-party due diligence reports. Broker-dealers should also consider the impact an issuer’s timeline has on the quality or thoroughness of a reasonable investigation.

In addition to the guidance set forth in Regulatory Notice 10-22, the Notice provides examples of  additional practices to help broker-dealers adequately discharge their responsibilities related to reasonable investigation and related supervision.

1. Offering-Specific Investigations.  A member’s process for conducting a reasonable investigation of a private placement should include attention to the circumstances surrounding a specific offering. These may include reviewing offer terms to determine whether they are reasonably structured for compliance with applicable rules, maintaining contact with the issuer to obtain updates on developments, and applying a heightened analysis when recommending investments with complex features or unique benefits to investors. Best practices also include refreshing and maintaining updated due diligence files and investigation records in connection with any follow-on offerings. 
2. Supervision of the Reasonable Investigation Process. To help maintain supervision of its private placement reasonable investigations under FINRA Rule 3110 (or to meet the requirements of Reg BI’s compliance obligation), a firm’s procedures may include using checklists that are reasonably designed to address the private placement; assigning responsibility to specific individuals or teams for the member’s private placement investigation; creating an alert system for notifying responsible individuals about filing deadlines; requiring documentation of the process, completeness, and results of its investigation and retention of documents obtained and implementing standards for the investigation process that address certain types of offerings sold by the firm; and attempting to verify that the member’s sale of an offering does not precede the completion of its reasonable investigation.

Customer-Specific Obligations 

With respect to Reg BI and Rule 2111, broker-dealers must obtain and analyze enough customer information to have a reasonable basis to believe that the recommendation is in the retail customer’s best interest, applying heightened scrutiny to risky or complex products (including private placements) and considering reasonably available alternatives.

Reg BI’s Disclosure, Conflict of Interest, and Compliance Obligations 

Under Reg BI, broker-dealers are required, before or during the recommendation, to provide a full and fair written disclosure of all material facts relating to the scope and terms of the relationship with the retail customer and all material facts relating to conflicts of interest associated with that recommendation. Examples of these material facts related to the scope and terms of the relationship may include the capacity in which the broker-dealer is acting, the material fees and costs applicable to the retail customer’s transactions, and the type and scope of services provided to the retail customers.

In addition, under Reg BI, broker-dealers are required to identify and address conflicts of interest that may incline broker-dealers, consciously or unconsciously, to make a recommendation that is not disinterested. Broker-dealers must establish, maintain, and enforce written policies designed to:

1. identify and disclose or eliminate all conflicts of interest associated with recommendations
2. identify and mitigate any conflicts of interest associated with recommendations that create incentives for associated persons to place their interest or the member’s interest ahead of the retail customer’s interest
3. identify and disclose any material limitations placed on the securities or investment strategies and any conflicts associated with such limitations
4. identity and eliminate sales contests, quotas, and other items that are based on the sale of specific securities

Lastly, broker-dealers must establish, maintain, and enforce written procedures designed to achieve compliance with Reg BI, including procedures outlining processes for complex or risky financial products, which include private placements.

Other Requirements Applicable to Private Placements 

Even in the absence of a recommendation, the Notice describes other key regulatory requirements relevant to private placement transactions:

1. Communications With the Public. Offering materials is considered a communication with the public under FINRA Rule 2210, if the member was involved in preparing the materials. Sales literature regarding private placements that members distribute generally also constitutes a communication with the public, whether or not the member assisted in its preparation.
2. Private Placement Filings With FINRA. Pursuant to FINRA Rule 5122 and 5123, FINRA requires members to submit a form that contains information about the member selling the private placement securities, the issuer, and the offering terms as well as any offering documents, if applicable. Both these rules also require filings to include member retail communications that promoted or recommended the private placement.
3. Supervision. FINRA Rule 3110 requires members to establish, maintain, and enforce supervisory systems and written procedures to supervise the types of business it engages and activities of associated persons. Procedures must be designed to verify that private placement offerings are properly supervised before being marketed to other members or sold directly to customers. Broker-dealers should periodically update their procedures, systems, and programs, such as by incorporating SEC staff guidance on Reg BI.
4. Private Securities Transactions (PST). FINRA Rule 3280 requires that associated persons and members exchange written notices and approvals from one another when PSTs involve selling compensation. If approved, the member must record the transaction and further supervise the person’s participation as if it were executed on their behalf. Last, when an associated person is recommending a private placement security in a PST to a retail customer, they must comply with all applicable rules, including Reg BI.

¹FINRA Rule 2111.08 Reg BI. This Rule governs general suitability obligations and shall not apply to recommendations subject to SEA Rule 15l-1.