On May 9, 2023, FINRA issued Regulatory Notice 23-08 (the “Notice”) to remind members of their obligations when selling private placements (i.e., unregistered securities sold pursuant to safe harbors of the Securities Act of 1933).
FINRA stresses that the Notice is not intended to modify guidance provided in prior Regulatory Notices—including Regulatory Notice 10-22—but rather to supplement the prior guidance in light of recent developments. The Notice begins with a discussion of recent developments regarding unregistered offerings, then discusses members’ regulatory obligations, and concludes with pointers on effective practices implemented by member firms.
In recent years, the unregistered offering market has been much larger than the public market. For example, in 2019, 69% of new capital was raised through unregistered offerings compared to 31% raised through public offerings. Most offerings were sold directly by issuers, with only about 20% being sold through an intermediary such as a FINRA member firm. However, as the unregistered offering market has grown, FINRA member involvement in these securities has grown as well. The number of unique filings for private placements filed by FINRA members nearly doubled from 2013 to 2021—growing from 2,000 to 3,800.
The Notice attributes this growth to legislative and regulatory developments that reduced restrictions and gave issuers alternatives to public offerings. However, with this growth, the SEC has remained focused on the risks to investors—including the illiquid nature of the securities and the lack of access to comprehensive information—and has imposed measures to reduce those risks.
Regulatory Requirements for Private Placements
The Notice highlights key obligations of member firms that participate in private placement transactions but also notes that there could be additional requirements in certain circumstances.
Best Interest and Suitability
Member firms must comply with Reg BI and FINRA Rule 2111 (Suitability) when recommending private placements, and FINRA details the following requirements for compliance.
- Duty to Conduct a Reasonable Investigation – Reg BI and the FINRA Suitability Rule require members who recommend a private placement to have a reasonable basis for that recommendation, and to have such, they must perform reasonable diligence on the offering. There are not clear rules for what is “reasonable,” but previous guidance provides that members should at least conduct an investigation concerning: the issuer and its management; the business prospects of the issuer; the assets held by or to be acquired by the issuer; the claims being made; and the intended use of offering proceeds. The new guidance also suggests that members consider:
- Regulatory and litigation history of the issuer and its management.
- New material developments such as ongoing legal proceedings or regulatory inquiries.
- Transactions involving offering proceeds between an issuer and its affiliates, including whether the arrangement presents a material conflict of interest.
- The issuers’ representations of past performance and whether they are misleading or cherry-picked.
Members should also demonstrate that they conducted a reasonable investigation by documenting their analysis, obtaining documents such as PPMs from the issuers, critically analyzing due diligence reports, and following up on red flags such as inconsistencies in due diligence reports.
- Customer-Specific Obligations – In accordance with Reg BI and the Suitability Rule, members also must have a reasonable basis to believe that a private placement is suitable for a particular customer’s investment profile. Relevant considerations in this analysis include:
- Whether the customer’s objectives are consistent with those of the private placement.
- The customer’s ability to withstand the risk of financial loss.
- Potential alternatives that would meet the customer’s objectives with less risk.
- Other Reg BI Component Obligations – The above discussions focused on Reg BI’s Care obligation, but Reg BI also includes obligations regarding Disclosure, Conflict of Interest, and Compliance.
- Disclosure Obligation – Members must disclose to retail customers all material facts relating to conflicts of interest, including the capacity in which the member is acting; the applicable fees and costs; and the type and scope of services provided to the customer. FINRA specifically notes that disclosure of conflicts alone does not satisfy the obligation.
- Conflict of Interest Obligation – Members must also identify and address conflicts of interest that could result in associated persons making a recommendation in which they have an interest. To do this, members must maintain policies and procedures reasonably designed to identify and disclose conflicts associated with recommendations; mitigate conflicts that create an incentive for associated persons to place their interest above those of their customers; disclose material limitations placed on securities and conflicts associated with those limitations; and eliminate compensation incentives that are based on the sale of specific securities.
- Compliance Obligation – Members also must establish and enforce written policies and procedures which are reasonably designed to achieve compliance with Reg BI.
Other Regulatory Requirements
The Notice continues with a non-exhaustive summary of other key regulatory requirements for members that engage in private placement transactions.
- Communications with the Public – FINRA Rule 2210 addresses Communications with the Public. Offering materials for private placements fall under this rule, and a member can be found in violation of the rule if they assist in the preparation of a misleading offering document or if they distribute misleading offering documents which they did not prepare.
- Private Placement Filings with FINRA – FINRA Rule 5122 and 5123 impose filing requirements on members that sell private placements. These Rules require members to submit forms through FINRA gateway that contain information about the member, the issuer, and offering terms.
- Supervision – FINRA Rule 3110 requires members to maintain supervisory procedures that are reasonably designed to ensure that private placement offerings are properly supervised. As with other supervision, if a member comes across red flags regarding private placements, they must investigate them.
- Private Securities Transactions – FINRA Rule 3280 requires associated persons to provide notice to and receive approval from their member firm before engaging in a private securities transaction that involves compensation. The Notice further provides that if a member approves such a transaction, they must record it and supervise the associated person’s participation with the transaction.
Effective Practices for Investigations and Supervisory Practices
The Notice concludes with effective practices FINRA has observed in its private placement examinations and member surveys.
Potentially effective practices for a member’s investigation of a private placement include:
- Determining whether the offering terms are reasonably structured for compliance with applicable rules and regulations.
- Staying in contact with the issuer to obtain updates.
- Taking additional steps to understand the risks and unique factors of private placements with complex features.
- Maintaining updated due diligence files when recommending new offerings by issuers upon which the firm previously conducted diligence.
Supervision of the Investigation Process
Potentially effective practices for supervision of private placement investigations include:
- Assigning investigation responsibilities to specific individuals and training them on applicable policies and requirements.
- Setting up alerts regarding upcoming filing deadlines.
- Documenting the process, including maintaining descriptions of meetings that were conducted with the issuer and of efforts to resolve identified red flags.
- Taking steps to ensure an offering is not sold before the conclusion of the investigation.
In sum, the number of private placement offerings have grown in recent years and will likely to continue to do so. Members should consider this Notice in developing or revising procedures reasonably designed to comply with their regulatory obligations regarding private placement offerings.
To read the regulatory notice, click here.