Corporate Finance & Securities

FINRA Guidance for Private Placement Due Diligence

If you’ve been following securities regulation over the past three years, you’ve likely noticed the increased FINRA scrutiny on private placement due diligence. Especially with respect to broker-dealers, the Financial Industry Regulatory Authority has cracked down on numerous firms that fail to take reasonable steps to investigate issuers before recommending an issuer’s securities to the broker-dealer’s  clients. There is the potential for an increase in private placements due to the recent legislation passed, the JOBS Act. Today’s post revisits some of the best practices that FINRA suggested in its Regulatory Notice 10-22, released in April 2010.

Reasonable Investigation Depends on the Circumstances
In general, broker-dealers are required to perform 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 in the offering documents, and the intended use of proceeds of the offering. The problem is that what constitutes “reasonable” depends on the facts and circumstances of the particular private placement sale.

Courts have found that the amount and nature of the investigation required depends on 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. For example, the SEC and courts have recognized that when securities are issued by a smaller company of “recent origin” (translated, a startup company with no financial history), the investigation requirements are heightened.

While there are no bright-line rules as to what a broker is required to do to meet his responsibility, the presence of any red flags should alert the broker-dealer of the need for additional investigation and inquiry. Red flags generally include anything that would alert a prudent person to conduct further inquiry into the issue. A broker-dealer is required to disclose any red flag to its clients. For example, the SEC has found that a broker cannot justifiably rely on financial statements in a Private Placement Memorandum that had been audited and certified by a CPA when numerous red flags indicated that the financial statements were inaccurate.

Ultimately, each broker-dealer must make a determination of the scope of investigation based on the facts and circumstances of each private placement.

FINRA Suitability Obligations
A broker-dealer must have reasonable grounds for recommending a purchase, sale, or exchange of a security as suitable for a client. FINRA provides two principal components of this analysis: (1) the reasonable grounds analysis requires the broker-dealer to have a reasonable basis, based on a reasonable investigation, that the recommendation is suitable for at least some investors; and (2) the “customer specific suitability” requires the broker-dealer to determine whether the security is suitable for the particular client to whom it was recommended. In terms of a private placement, the broker-dealer must conduct a suitability analysis when recommending securities to both accredited and non-accredited investors that will take into account the investors’ knowledge and experience.

Keep Records to Prove Your Reasonable Investigation
A broker-dealer should always retain all records that document the process and results of its investigation in order to demonstrate that it has performed a reasonable investigation. These records may include descriptions of the meetings, including meetings with issuers, the tasks performed, the documents and other information reviewed, the results of such reviews, the date of important events that occurred, and a list of the individuals who attended the meetings and conducted the reviews.

If you’d like to learn more about the due diligence process for private placements or the private placement process in general, please don’t hesitate to contact us today.


Gavin Johnson

Gavin enjoys craft beer and is learning the art of brewing.

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