In late 2010, the United States Financial Fraud Enforcement Task Force announced the results of “Operation Broken Trust”.
Posted on Friday, February 4, 2011 at 11:55 AM

FINRA (the Financial Industry Regulatory Authority) recently discussed its investor protection priorities at a conference held for independent financial services firms.  Unfortunately for that audience, FINRA stated that it has targeted the two products that they sell to customers a great deal: private placements (otherwise known as “Reg D” offerings) and non-traded real estate investments trusts (REITs).  Indeed, speaking for FINRA, James Shorris, executive vice president and executive director of enforcement, commented that Reg D deals are a “major, major initiative at FINRA.”

 

            FINRA’s concern stems from the fact that financial services firms have fallen short in a market estimated to be north of $600 billion in 2008, and growing fast.  Financial services firms have failed to conduct due diligence before recommending private placements to customers, and likewise have breached their duty to ensure that their recommendations to purchase private placements are suitable for each and every customer sold the product.  Like non-traded REITs, those Reg D deals are unsuitable for those needing income because they are illiquid.  They also are unsuitable for those needing more conservative investments because they are risky.  Notable recent examples that Mr. Shorris cited include Medical Capital Holdings, Inc. and Provident Royalties, LLC, private placements that raised hundreds of millions of dollars through sales by independent financial services firms, until the Securities and Exchange Commission charged both entities with fraud.

 

            Financial services firms that recommend private placements must clear high compliance hurdles beforehand.  FINRA Regulatory Notice 10-22 is the most comprehensive discussion of the due diligence requirements that FINRA has imposed.  Any customer who is considering bringing a claim for negligence and breach of fiduciary duty (for failure to conduct sufficient due diligence and for making an unsuitable recommendation) is advised to begin the analysis there.

 

Preliminarily, Regulatory Notice 10-22 states that the "amount and nature" of the due diligence investigation depends upon several factors, including "the nature of the recommendation, the role of the broker in the transaction, its knowledge of and relationship to the issuer, and the size and stability of the issuer."  Certainly, a "more thorough investigation" is required for securities issued by smaller companies of recent origin.  Similarly, the presence of any "red flags" also would alert the firm to the "need for further inquiry."

 

Importantly, a firm that "lacks essential information about an issuer or its securities" when it makes a recommendation "must disclose this fact as well as the risks that arise from its lack of information."  FINRA reminds firms that they "may not rely blindly upon the issuer for information concerning a company."  Indeed, firms cannot rely upon the issuer or upon the issuer's counsel in lieu of conducting their own reasonable investigation.

 

Critically, in their investigations firms must exercise a "high degree of care."  Firms must "independently verify an issuer's representations and claims."  If the offering is a "speculative venture", firms "must be particularly careful in verifying the issuer's obviously self-serving statements."  The regulatory notice further states that the firm's duty to investigate is not obviated by the fact that the firm's customers (that is, the purchasers of the private placement) are sophisticated and knowledgeable.

 

In connection with the suitability of private placement recommendations, FINRA expects firms, at a minimum, to conduct a reasonable 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 proceeds of the offering

 

Notably, this investigation must be in connection with each private placement offering, notwithstanding the fact that the subsequent offering may be for the same issuer.

 

Likewise, sometimes the financial services firm prepares the private placement memorandum, a document that describes the offering to prospective purchasers.  How does that alter its duties?  FINRA responds by stating that the firm has a duty to investigate the securities offered as well as the representations made by the issuer in the private placement memorandum.  FINRA considers such a document to be a "communication with the public", and as such, the document must be fair, balanced, and not misleading.  Likewise, any sales literature concerning a private placement which the firm distributes generally is considered to be a communication with the public.  Firms thus must ensure that such sales literature is fair, balanced and not misleading, whether or not they assisted in its preparation.  

 

Finally, what happens when firms discover “red flags" during their investigation?  FINRA responds by stating that firms must note and follow up on any such information, including "to investigate any substantial adverse information about the issuer."  Put another way, when presented with red flags, firms "must do more than simply rely upon representations by issuer's management, the disclosure in an offering document or even a due diligence report of issuer's counsel."  Importantly, should an issuer refuse to provide the firm with information that is necessary for the firm to meet its duty to investigate, that fact alone could constitute a red flag.

 

As one can see, Regulatory Notice 10-22 places a substantial burden on financial services firms to do their homework before recommending private placements to their customers.  Coupled with FINRA’s identifying private placements as its number one investor protection priority, investors may well receive the protection that they deserve in this “Wild West” environment!  And, in more good news for investors, FINRA recently has sought comment and has proposed amendments to the current rules imposing additional duties on financial services firms deemed to be “participating” in a private placement, which I will address in a subsequent article.

   

 

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