Summary

FINRA settled with a placement agent for failing to perform due diligence and supervise an employee in connection with the placement of securities by the placement agent in a Regulation D offering.

The Upshot

• According to the settlement, the transaction involved sale of Regulation D securities to a qualified institutional buyer of preferred stock of a publicly listed company in the amount of $10 million.
• The placement agent’s due diligence file was deemed insufficient because it contained only an email with a hyperlink to public EDGAR filings and the stock purchase agreement, which contained the terms of the transaction.
• The placement agent did not document the “process or results of a reasonable investigation into the issuer of the preferred stock shares, meetings, tasks performed, and documents and information reviewed as described by FINRA Regulatory Notice 10-22 and required by the firm’s own written procedures.”

The Bottom Line

Placement agents who remain skeptical of FINRA’s inclination to enforce due diligence and suitability obligations for placements to sophisticated counterparties of publicly listed offerings should take note of this settlement. Placement agents also should consider whether their written due diligence procedures for vetting private placements are sufficient, whether they are actually followed, and whether their documentation of the “process and results of due diligence” creates a reasonable evidentiary record of the inquiry that matches their written procedures.

FULL ALERT

On September 23, 2020, FINRA settled with a placement agent for failing to perform due diligence and supervise an employee in connection with the placement of securities by the placement agent in a Regulation D offering.

In settling with the placement agent, FINRA reaffirmed its previous reminder in FINRA Regulatory Notice 10-22 ("Notice 10-22") that placement agents have an obligation to conduct a reasonable investigation of the issuers and the securities they recommend; placement agents must have supervisory procedures that are reasonably designed to ensure that personnel engage in an inquiry of a private placement that is sufficiently rigorous; and that the firm’s personnel must perform a suitability analysis for customers under FINRA Rule 2111, formerly NASD Rule 2310.   

According to the settlement, the transaction involved a sale of Regulation D securities to a qualified institutional buyer of preferred stock of a publicly listed company in the amount of $10 million. The placement agent’s due diligence file was deemed insufficient because it contained only an email with a hyperlink to public EDGAR filings and the stock purchase agreement, which contained the terms of the transaction.

The placement agent did not document the “process or results of a reasonable investigation into the issuer of the preferred stock shares, meetings, tasks performed, and documents and information reviewed as described by Notice 10-22 and required by the firm’s own written procedures.” FINRA warned that placement agents should retain records describing both the “process and the results” of a due diligence investigation.

Placement agents who remain skeptical of FINRA’s inclination to enforce due diligence and suitability obligations for placements to sophisticated counterparties of publicly listed offerings should take note of this settlement. The settlement is a reminder that placement agents have suitability obligations to purchasers of private placements under both MSRB Rule G-19, applicable in connection with municipal securities, and FINRA Rule 2111.

While both rules have customer level suitability exclusions for certain sophisticated purchases under defined circumstances, which would likely have applied here since the purchaser was a qualified institutional buyer, both rules also require a product level due diligence inquiry notwithstanding purchaser sophistication. Called the “reasonable-basis obligation,” this duty requires a broker, dealer, or municipal securities dealer to have a reasonable basis to believe, based on reasonable diligence, that the recommendation is suitable for at least some investors.

Placement agents should consider whether their written due diligence procedures for vetting private placements are sufficient, whether they are actually followed, and whether their documentation of the “process and results of due diligence” creates a reasonable evidentiary record of the inquiry that matches their written procedures.