FINRA Re-Emphasizes Private Placement Risks In Light Of 2012 Jobs Act

Posted on September 27th, 2013 at 5:32 PM

The 2012 Jobs Act, which takes effect September 23, 2013, drastically changes the way companies can solicit and advertise private securities offerings (also known as private placements) under Rule 506 of Regulation D.  Historically, companies claiming an exemption under Regulation D were prohibited from engaging in general solicitation or using advertising to market securities.  Under the new rules, the floodgates will open as companies will be able to do so, including through Internet crowdfunding platforms. 

            FINRA (the Financial Industry Regulatory Authority) is concerned and has an issued an Investor Alert.  The alert warns, “While the target audience will be accredited investors, the reality is that all investors – whether accredited or not – will likely be exposed to private placement sales pitches and advertising….”  Importantly, securities regulators neither review nor approve the private placement offerings to ensure that the companies are disclosing to the accredited investors all of the material facts and the risks associated with the investment. Accredited investors are defined as investors who have a net worth, exclusive of primary residence, of at least $1 million and who also have income exceeding $200,000 ($300,000 if filing jointly with a spouse) in each of the two most recent years along with a reasonable expectation of the same income level in the current year.

            FINRA bases much of its investor alert on its previously issued FINRA Regulatory Notice 10-22.  Financial services firms will be expected to continue abiding its requirements. Let’s highlight those requirements.

Regulatory Notice 10-22 begins with the statement that the "amount and nature" of a financial services firm’s 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.


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.  Given That burden will be an increasingly challenging task given the expected substantial number of private placements being solicited and advertised under the 2012 Jobs Act.

Related Attorneys: James J. Eccleston


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