FINRA Actions and the Due Diligence Obligations of Broker-Dealers in Private Placements


Private placements and the due diligence obligations of broker-dealers in such transactions have recently come under increased scrutiny from FINRA as part of a broader trend reflected most notably in the filing requirements for private placements that went into effect on December 3, 2012 (FINRA Rule 5123). This trend of increased scrutiny also is likely to continue in light of the SEC’s recent adoption on July 10, 2013, pursuant to Section 201(a) of the JOBS Act, of final rules relaxing the prohibition on general solicitation and general advertising for certain private placements under Rule 506 of Regulation D.

For example, on July 17, 2013, FINRA approved a Letter of Acceptance, Waiver and Consent submitted by Sunset Financial Services, Inc. in connection with alleged violations of NASD Rules 3010(a) and 2110 and FINRA Rule 2010. This matter involved private placements for two funds, one a bridge loan lender of short-term mortgages secured by real property and the other an acquirer of discounted debt from distressed banks and other leveraged financial institutions. FINRA cited an increased default rate for the loan portfolio of the first fund of approximately 20% (which was a red flag given the relevance of default risk to the fund’s business) and the broker-dealer’s failure to follow-up or re-evaluate the appropriateness of retaining the fund on its approved list, even in light of subsequent suspended redemptions and monthly distributions. FINRA pointed out that the broker-dealer also did not wait for the completion of a third party due diligence report on the second fund before placing the fund on its approved list, nor did it perform enhanced due diligence even though the second fund had the same management as the first fund. FIRNA also highlighted that the broker-dealer delegated nearly all responsibilities relating to private placements to a single person, its vice president in charge of products and sales, who was responsible for conducting due diligence on private placements, determining which private placements to approve for sale by registered representatives, formulating recommendations for private placements and monitoring suitability, as well as the absence of written supervisory procedures other than a generic checklist. FINRA emphasized the broker-dealer’s lack of adequate supervisory policies and procedures to review and monitor due diligence on approved private placements, suitability of the securities for customers, sales material provided to customers and internal use materials provided to registered representatives.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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