Broker dealers must follow certain policies and procedures in examining securities. This obligation is a requirement of the Financial Industry Regulatory Authority (FINRA) Notice 10-22 for all Regulation D offerings.
Broker dealers must provide adequate supervision of all activities that are related to Regulation D offerings. To ensure supervision is adequate, they must conduct an investigation into the security which is being offered. This investigation must meet the standards considered to be reasonable. It must also be deemed to be suitable based on information the broker dealer has about the client.
The broker dealer should only sell securities to clients who are considered appropriate for the offering. In addition, they must meet the requirements of the antifraud provisions of the FINRA rules when preparing a PPM or other documents for an offering.
How to Document the Investigation
One of the most important steps in conducting an investigation into a security is reviewing “proper documentation.” The entire investigation process should be thoroughly conducted including: (1) maintaining a record of documents that were reviewed, (2) recording the steps that were taken to review these documents, and (3) recording the investigation findings. This protects the broker dealer by supporting the assertion that they performed what would be considered a “reasonable investigation.”
Records that would be included within the description of “proper documentation” should be the materials listed below under “Aspects of the Investigation.” All documents that are reviewed should be logged, along with the person who conducted the review and the results of the review.
Another method of proper documentation includes maintaining a checklist. Even though a broker dealer should conduct an independent investigation relevant to each individual security, the checklist will serve as a reminder to include all pertinent information and to ensure that the standards for a reasonable investigation have been met.
Aspects of the Investigation
The reviewer should also examine and make inquiries about numerous aspects of the issuer and the security being offered. Some methods of investigation would include the following:
- Examine the governing documents of the issuer such as the charter and bylaws;
- Examine financial statements, both current and past;
- Inquire about the date of the beginning of business and any proposed changes to the business;
- Inquire about various forms of compensation used for management;
- Inquire about the details of management for the issuer;
- Determine if any prior regulatory or disciplinary action occurred for the issuer;
- Inquire about any prior offerings;
- Inquire about affiliates of the issuer;
- Review business plans from issuer;
- Review industry and future prospects;
- Inquire about intellectual property of the issuer;
- Review the financial model of the issuer;
- Review assets, including visiting the facilities owned and operated by the issuer;
- Obtain export opinions and reports from third parties.
While each security investigation will be unique to the issuer, these best practices are guidelines that may be used to determine if the investigation meets the requirements of the FINRA. The term “reasonable investigation” may be left open to interpretation, but following a checklist for most practices will ensure that the requirements have been met.