The Financial Industry Regulatory Authority’s (“FINRA”) 2018 Examination Findings Report regarding broker-dealer (“firms” or “members”) examinations made it clear that it had targeted due diligence for private placements as a part of its core examination program of members. Ultimately, the Examination Findings Report focused on a number of observations from recent FINRA examinations, but it describes observations made by FINRA regarding the lack of reasonable due diligence in the marketing of private placements. These observations should be of interest to those members actively marketing private placements.
To this end, FINRA’s observations in the Examination Findings Report focused on the lack of reasonable due diligence for private placements and presents a clear view of FINRA’s current expectations. FINRA has historically observed instances where some firms that have suitability obligations under FINRA Rule 2111 (Suitability) failed to conduct reasonable diligence on private placements and failed to meet their supervisory requirements under FINRA Rule 3110 (Supervision). However, in its selected examination findings, FINRA drilled down on this issue as it noted a number of instances where some firms’ reasonable diligence was not sufficient in scope or depth to be considered a “reasonable investigation of the issuer and the securities.”
To this end, FINRA the Examination Findings Report noted that those deficiencies included:
No Reasonable Diligence
Some firms failed to perform reasonable diligence on private placement offerings prior to recommending the offerings to retail investors. In some instances, firms performed no additional research about new offerings because they relied on their experience with the same issuer in previous offerings. In other instances, some firms reviewed the offering memorandum and other relevant offering documentation, but did not discuss the offering in greater detail with the issuer or independently verify, research or analyze material aspects of the offerings. FINRA also observed that some firms did not investigate red flags identified during the reasonable due diligence process. For example, in offerings involving conservation tax easements, some firms did not investigate red flags that included, but were not limited to, significant risk of the Internal Revenue Service (IRS) disallowing tax deductions, as well as concerns regarding land appraisals.
Over Reliance on Third Parties
FINRA observed that where some firms obtained and reviewed due diligence reports provided by due diligence consultants, experts or other third-party vendors, they sometimes did not independently evaluate the third parties’ conclusions, respond to red flags or significant concerns noted in the reports, or address concerns regarding the issuer or the offering that were apparent outside the context of the report.
Potentially Conflicted Third-Party Due Diligence
Additionally, some firms used third-party due diligence reports that issuers paid for or provided in their due diligence analysis. While some of these reports provided valuable and relatively objective information, in some cases, firms did not consider the related conflicts of interest in their evaluation and assessment of the reports’ conclusions and recommendations.
Take Away for Members
While the Examination Findings Report does not purport to represent a complete inventory of FINRA observations regarding private placements, the observations should be helpful to members so as to allow them to improve their compliance practices and processes based on the experiences of other firms who are marketing private placements. The core observation for members is that while FINRA has not changed its views on product due diligence, it is clear that it has increased its focus on the due diligence efforts of firms marketing private placements. To that end, members marketing private placements need to review their current due diligence practices to determine if they comply with FINRA’s expectations. As compliance weaknesses are identified, action should be taken to strengthen those processes so as to address potential areas of concern in advance of their own FINRA examinations.