Broker-Dealer Rules During the Private Placement of Securities.
When involved in the private placement of securities under Regulation D of the federal securities law, broker-dealers (BDs) are obligated under both SEC and FINRA rules to exercise discretion when recommending securities to clients. FINRA’s ethical and anti-fraud rules and the SEC’s rules governing securities fraud are all implicated during a privately placed transaction under Regulation D in which a BD was apart.
Although much more could be written on the topic, Regulation D (Reg D) offers a safe harbor for the private placement and limited placement of securities under section 4(2) of the Securities Act. After meeting the standards of the regulation and filing the appropriate forms with the SEC the offering of securities will be considered privately placed under section 4(2). These transactions are not registered with the SEC. Because of the unregistered nature of these transactions FINRA has imposed special rules on BDs that recommend Reg D securities to their clients/customers. Violating these rules could lead to liability not only for the particular BD but also his or her firm.
FINRA Requirements for BDs During Reg D Offerings
- Prior to making a recommendation to a client, a BD must make a reasonable investigation as to the sustainability of the investment for the particular customer and must make the recommendation based on that investigation. Making a recommendation without such an investigation may violate FINRA rule 2010 and FINRA rule 2020.
- What is reasonable in terms of an investigation will be based on various factors surrounding the role of the BD in the transaction, the nature of the client-broker relationship, and the nature of the issuer.
- A BD that lacks essential information about an issuer of Reg D securities must disclose this fact prior to making a recommendation as well as risks that arise from its lack of information, again implicating FINRA rule 2010 and FINRA rule 2020.
- FINRA, under NASD rule 2310, specifically requires that a BD must have reasonable grounds to believe that a recommendation to purchase, sell or exchange a security (in any transaction) is suitable (sustainable) for the customer. This rule also applies to Reg D offerings. Sustainability looks both at the general sustainability of the product and the sustainability for the particular customer. This requirement ties back into the reasonable investigation requirement.
- In order to full his or her investigation requirements as it pertains to sustainability a BD should look to, among other things:
o the issuer and its management;
o the business prospects of the issuer;
o the assets held by or to be acquired by the issuer;
o the claims being made by the issuer; and
o the intended use of the proceeds of the offering.
- There are special rule requirements under NASD rule 2210, pertaining to advertising, that are triggered if the BD helps prepare the private placement memorandum, other offering document, or sales literature or if the BD distributes such materials, the complexity of which are outside the scoop of this post.
- Each investigation should be tailored to the specific Reg D offering and each BD and his or firm should record the investigation efforts. BD firms under NASD rule 3010 are responsible for supervising their BD’s during the investigatory process.
- These requirements apply whether or not the investor/customer is accredited or non-accredited under SEC rules
- As always, SEC rule 10b-5 (anti-fraud provision) will always be in play if the BD makes a recommendation that he does not believe he should be making or makes a recommendation without doing an adequate investigation.
- Any involvement that the BD has in the offering process, i.e. helping to prepare offering documents or distributing offering documents, will also implicate rule 10b-5.
*For further information on these issues, please see FINRA Notice 10-22.