One area that continues to be of concern for the Financial Industry Regulatory Authority (FINRA) is private placement securities. In 2014, FINRA released a Regulatory and Examination Priorities Letter that details these concerns. In essence, it is a continuing priority for FINRA to supervise the activities of private placement offerings through information found in the Rule 5123 filings. The goal is to be able to identify offerings that are a higher risk for investors. As approved, FINRA Rule 5123 requires members selling securities issued by non-members in a private placement to file the private placement memorandum, term sheet or other offering documents with FINRA within 15 days of the date of the first sale of securities, or to indicate that there were no offering documents used. There are, however, exceptions to this rule for specific types of offerings.
A Growing Issue
According to FINRA, many Rule 5123 filings are showing problems including inadequate due diligence performed by broker dealers. Broker dealers should be conducting investigations into private placement securities based on requirements set forth with Notice 10-22. FINRA, however, has discovered that many broker dealers are recommending private placements without fully evaluating the financial capacity of the issuer principals. There are many concerning factors when evaluating an issuer’s financial capacity, but the more evident factors would include failure to pay bills, defaulting on specific liabilities, or using proceeds from multiple private placements to pay other investors. Another issue that FINRA has frequently discovered is deficiencies in contingency offerings escrows.
Furthermore, the availability of Regulation D Rule 506(c) offerings, which enable general solicitation for marketing private placements, presents unique challenges to broker dealers and their firms due to difficulties in determining how suitable an investment is for an investor with whom the firm had no prior substantial relationship.
One of the problems mentioned in the 2014 letter includes the lack of independent financial information and, frequently, a lack of information regarding the issuer’s market and risks associated therewith. Accordingly, three tasks of broker dealers in their investigations should be: (a) an evaluation of the creditworthiness of the issuer, (b) an examination of the integrity and validity of the business model, and (c) the likelihood and reasonableness of expected returns as compared with industry returns.
FINRA recommends that every investigation be unique, but all investigations should follow predefined policies and procedures to ensure that the broker dealer meets its due diligence obligations before recommending a security. A properly created checklist can help to ensure that all necessary steps have been taken to meet the requirements as defined in Notice 10-22. Broker dealers and firms that do not have the time or capability of meeting these guidelines are at risk for disciplinary action, which is why hiring a third party can be indispensable to many broker dealers.