Executive Summary: FINRA has found fraud and sales practice abuses in several Regulation D (Reg D) offerings. Reg D offers exemptions from registration requirements, but does not exempt broker-dealers from conducting thorough investigations of securities and other antifraud requirements. FINRA Notice 10-22 reminds members as to their obligation in such offerings.
The following article provides some points that broker-dealers must consider when engaging in Reg D offerings.
Reg D - Regulation D has several different exemptions from registration as outlined below.
Rule 504:
- Provides registration exemption for limited offerings where aggregate offering price of securities within a 12-month period does not exceed $1 million.
Rule 505:
- Provides registration exemption for limited offerings where aggregate offering price of securities within12-month period does not exceed $5 million.
- Permits offering to an unlimited number of accredited investors and up to 35 non-accredited investors.
- Must provide written information to non-accredited investors who purchase an offering.
Rule 506:
- Provides registration exemption for sale of securities to unlimited number of accredited investors and up to 35 non-accredited investors.
- Does not limit size of offering.
- Requires non-accredited investors possess financial knowledge and experience.
- Must provide written information to non-accredited investors who purchase an offering.
Broker-Dealer Regulatory Requirements in Regulation D offerings
The obligations outlined in FINRA Notice 10-22 and covered in a recent FINRA webinar include:
Anti-Fraud Requirements:
- The broker-dealer must conduct a reasonable investigation of the issuer and its securities prior to giving recommendations
- The scope of an investigation will depend upon the recommendation, role of the broker in the transaction, knowledge of the issuer, and the size and stability of issuer
- The broker-dealer must disclose lack of essential information and the potential risks from lack of information
- The fact that an investor is accredited/sophisticated does not relieve the duty to investigate
Suitability Obligations:
- The broker-dealer must conduct suitability analysis for accredited and non-accredited investors
- The broker-dealer must gather information concerning customer's:
• Other holdings
• Financial situation and needs
• Tax status
• Investment objectives
• Other information deemed as appropriate
- The broker-dealer should conduct a reasonable investigation concerning:
• Issuer and its management
• Business prospects of issuer
• Assets held by or to be acquired by issuer
• Claims being made
• Intended use of proceeds from the offering
Other Broker-Dealer Responsibilities:
- The broker-dealer's affiliation with an issuer must not compromise independent investigation
- A broker-dealer that prepares the private placement memorandum or other offering documents must investigate:
• Securities offered under Reg. D; and
• Issuer's representations in memorandum or other documents
- NASD Rule 2210 applies to communications with the public:
• Private placement memorandum or other offering documents that the broker-dealer
assisted in preparing
• Private placement sales literature that the broker-dealer distributes, regardless of
whether the broker-dealer assisted in the preparation
- The broker-dealer must investigate any possible "red flags" such as:
• Issuer's refusal to provide information necessary to fulfill duty to investigate offering
• Non-responsive behavior or out-of-date information
• Absence of a private placement memorandum
- A broker-dealer may retain qualified assistance in conducting investigations, but the broker-dealer must fill in any gaps or omissions in these efforts
- If the broker-dealer determines a syndicate manager has expertise and absence of conflict to conduct an independent, thorough investigation, the broker-dealer can rely on that investigation. However, if the broker-dealer should become aware of any gaps in the syndicate manager's efforts, the broker-dealer must retain responsibility
Supervision:
- The broker-dealer must have supervisory procedures reasonably designed to ensure registered representatives and other personnel:
• Engage in a sufficient investigation
• Perform appropriate suitability analysis
• Determine eligibility of customers to purchase Reg. D securities
• Do not violate antifraud provisions preparing or distributing offering documents
or sales literature
Documentation of Reasonable Investigation:
- The broker-dealer should document and retain information about the investigation, including:
• Meetings conducted with issuer or other parties
• Tasks performed
• Information reviewed
• Results of reviews
• Dates of event(s)
• Individuals who attend meeting(s) and/or conducted review(s)
General Principles:
- The scope of the investigations is based on facts and circumstances
- Reliance on a checklist may result in an inadequate investigation
- The broker-dealer cannot rely upon the issuer and its counsel for information in lieu of conducting an investigation
- The broker-dealer should stay alert to the presence of red flags
Issuer and Management
- Examine governing documents such as:
• Issuer's charter
• By-laws and partnership agreement
• Documents that note amount of authorized stock and any restriction of activities
- Examine historical financial statements of issuer and affiliates, including any that have been audited, and look for trends
- Inquire about affiliates and their cash needs
- Inquire about internal audit controls
- Contact customers and suppliers
- Review contracts, leases, mortgages, and financial and contractual arrangements
- Inquire about past securities offerings
- Inquire about any pending litigation of issuer or affiliates
- Inquire about previous or potential regulatory or disciplinary problems
- Conduct credit check
- Inquire about issuer's management, including expertise and whether changes in management have happened or are expected
- Inquire about the amount of management compensation, who determines compensation and how forms of compensation could possibly present conflicts of interest
- Inquire about the length of time issuer has been in business and whether the focus of the business is about to change
Issuer's Business Prospects
- Inquire about the issuer's intellectual property and about the industry in which the issuer conducts business
- Request a business plan and financial models
- Maintain a summary of analysis of financial models
Issuer Assets
- Visit and inspect a sample of the issuer's assets and facilities and determine whether value is reasonably reflected in financials
-
Examine geological, land use, engineering or other third-party reports
Recent Private Offering Cases
Some recent cases against members engaged in Reg D offerings highlighted in the webinar included:
Pacific Cornerstone (Press Release dated December 21, 2009)
- FINRA found no reasonable basis for firm's statements in offering documents of 18% yield and return of principal in 2 to 4 years
- Firm fined $700,000 and agreed to make corrective disclosures to investors
- Former CEO also named in action and was suspended in all capacities for 20 days, suspended for principal capacities for an additional three months, and fined $50,000
Provident Asset Management, LLC (Press Release dated March 18, 2010)
- FINRA found firm made various misrepresentations to investors regarding the use of investor funds to market private placements for affiliated companies
- Affiliated companies moved investor funds freely between accounts, and new funds were used to pay earlier investors' dividends and principal, evidence of a classic Ponzi scheme
- Firm expelled
McGinn, Smith & Co. (Press Release dated April 19, 2010)
- FINRA complaint alleges failure to disclose several material facts in connection with four offerings and investments not performing as promised
- Action pending
FINRA and the SEC are taking a close look at how members are conducting themselves when engaging in Reg D offerings, to ensure that various provisions of securities rules and regulations are being followed and that the firms are looking out for the interests of investors in these offerings. One of FINRA's examination priorities for 2010 will be in reviewing books and records relating to Reg D offerings to ensure firms are meeting these obligations.
If you have questions about FINRA's Notice or how this may apply to your firm, please contact your Regulatory Compliance account manager at 603-434-3594.
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