Learn How Due Diligence Regulations Protect Investors Seeking Private Placement Transactions

Even the most knowledgeable investor isn’t expected to go it alone when it comes to making decisions on what securities to buy. While broker-dealers offer their clients public securities, which most investors are familiar with, broker-dealers may also offer private placements, an important part of the investment landscape with unique risks and rewards. When brokerages offer private placements, they are required to conduct appropriate due diligence of the issuer, management of the issuer and affiliates of the issuer in order to ensure that the securities are suitable and appropriate.

How Private Placements are Unique

While private securities may be exempt from some common securities regulations, this doesn’t relieve broker-dealers of their responsibility to act in their clients’ best interest at all times. Financial Industry Regulatory Authority (FINRA) Notice to Members 10-22 sets forth the due diligence requirements of brokerages with respect to private placement securities offerings. NTM 10-22 can also be helpful information for investors who want to better understand broker-dealer roles and responsibilities in the private placement of securities.

Under specific circumstances, broker-dealers may offer their clients securities called private placements, which are generally issued by smaller companies, and where the aggregate value of these securities offered in a 12-month period is limited. Private placements may be offered to accredited and non-accredited investors. Accredited investors meet–or are reasonably believed to meet by the broker-dealer–minimum net worth or income thresholds. These investors are also expected to possess a competent understanding of how investing works in order to make a reasonable and reliable judgment on the potential risks and rewards of a given investment. While issuers are required to provide certain documents to potential non-accredited investors, they are exempt from providing these documents to accredited investors; according to FINRA, though, issuers typically make private placement memorandum available to non-accredited and accredited investors alike.

The Role of Due Diligence

There’s a long-standing regulatory and legal precedent that assigns broker-dealers some degree of responsibility when recommending securities to their customers. According to FINRA, the broker-dealer has a “special relationship” with customers and in making recommendations to them, suggests that the securities have met minimum standards as to worthiness on the part of the broker-dealer. Even in the cases of private placements to accredited investors, broker-dealers cannot trust that even the affluence and sophistication of accredited investors relieve them from the responsibility of due diligence. When broker-dealers fail in upholding this standard, it may be considered fraud and a violation of FINRA Rules 2010 and 2020, which govern just and equitable principles of trade and bar manipulative and fraudulent devices.

The level of due diligence to be carried out by broker-dealers can vary by issuer and the type of securities; in some ways, broker-dealers are left to their own judgment as to what’s a red flag for their clients. However, there are some overarching principles that guide broker-dealers. Broker-dealers are obligated to independently verify issuer claims, identify and investigate red flags, and follow suitability rules when making recommendations to their clients. Broker-dealers should consider any association or affiliation with the issuer; they must carefully consider any possible or potential for actual or perceived conflict of interest. Broker-dealer supervisory procedures must establish minimum standards in line with regulatory requirements for due diligence, and broker-dealers should also hold onto all records documenting their due diligence activities.

Broker-Dealers’ Best Practices for Due Diligence

By following best practices for due diligence, broker-dealers can provide clients with all of the information they need to make informed decisions on the risk and rewards of private placements. Here are some of the most important tasks:
● Investigate the issuer and the company’s management, including company history and background, and the qualifications of the management team to conduct relevant business. This includes reviewing governing documents, bylaws, historical financial statements, audits, and internal audit controls. Broker-dealers should identify any trends based on financial statements, interview the issuer’s customers and suppliers, and review the issuer’s leases and mortgages.
● Research affiliates of issuers to the extent that affiliates’ needs may influence the issuer.
● Explore any previous securities offerings from the issuer, along with pending litigation, regulatory issues, disciplinary problems, management expertise and compensation, and long-term business plans.
● Review the issuer’s assets, and consult with industry experts as needed to make a proper assessment of an issuer’s securities.

When considering private placement securities, your broker-dealer can be your best resource for finding suitable investments aligned with your risk tolerance and financial goals. In the event a broker-dealer offers private placement securities without the proper due diligence, investors may be able to recover some of their losses.

The Wolper Law Firm, P.A. represents investors nationwide in securities litigation and arbitration on a contingency fee basis. Matt Wolper, the Managing Principal of the Wolper Law Firm, P.A., is a trial lawyer who has handled hundreds of securities cases during his career involving a wide range of products, strategies and securities. Prior to representing investors, he was a partner with a national law firm, where he represented some of the largest banks and brokerage firms in the world in securities matters. We can be reached at 800.931.8452 or by email at mwolper@wolperlawfirm.com.

Attorney Matthew Wolper

Attorney Matthew WolperMatt Wolper is a trial lawyer who focuses exclusively on securities litigation and arbitration. Mr. Wolper has handled hundreds of securities matters nationwide before the Financial Industry Regulatory Authority (FINRA), American Arbitration Association (“AAA”), JAMS, and in state and federal court. Mr. Wolper has handled and tried cases involving complex financial products and strategies ranging from traditional stocks and bonds to options, margin and other securities-based lending products, closed/open-end mutual funds, structured products, hedge funds, and penny stocks. [Attorney Bio]