As broker/dealers continue to expand their inventories of products and look for new sources of revenues, they have increasingly turned to offerings of private placements. As sales of these products to retail investors have increased, so has the incidence of sales practice abuses. Not surprisingly, this trend has captured the attention of FINRA and the claimants' bar, who have likewise increased their focus on these products. FINRA recently announced that private placements will be a subject of examinations and enforcement actions in 2010 and beyond.¹ For the claimants' bar, claims relating to private placements represent a potentially lucrative source of revenue.

Two recent events underscore the regulatory and litigation risks associated with private placements offered by broker/dealers. First, FINRA fined a California broker/dealer and its principal $750,000 for alleged misrepresentations and omissions in the sale of private placements. Second, a group of investors in an unrelated action filed suit in federal court in Idaho against an issuer of private placements and is seeking certification as a class action. The broker/dealer through whom the investments were sold is also a named defendant.

Broker/dealers and their registered reps who underwrite and participate in the distribution of Regulation D offerings will be well served to fully understand and comply with the requirements of Reg D and applicable FINRA rules. This article will provide a brief overview of Reg D and some tips for managing the regulatory and litigation risks attendant to these products.

Reg D offerings are sometimes used as a source of funding for upstart and developmental stage companies which cannot yet qualify for registration or otherwise choose not to go through the sometimes cumbersome and expensive process of registering their securities for sale in the public markets. Rule 504 of Reg D provides one of several exemptions from the registration requirements of the Securities Act of 1933 for some companies when they offer and sell up to $1 million of securities in a 12¬month period. Among other restrictions, Rule 504 does not permit companies to advertise or solicit sales from the general public, and purchasers receive restricted shares, such that they cannot resell the securities to other purchasers absent registration or an exemption from registration. Rule 504 allows sales of unregistered securities if certain state registration requirements are met, and/or sales are made to "accredited investors." The particular requirements are beyond the scope of this article, and you should consult legal counsel for guidance.

FINRA will likely focus its inquiries on: (1) potential misrepresentations and omissions made in connection with the sales; (2) whether they are suitable for the investors who purchase them; (3) whether the broker/dealer conducted adequate due diligence before offering the investments, and (4) whether the broker/dealer had undisclosed conflicts of interest with the issuers. Broker/dealers and their registered reps can take steps to insulate themselves from the heightened regulatory scrutiny and litigation risks. As with other products, the recipe is fairly straightforward but requires diligent implementation and regular ongoing review and updates.

Appropriate due diligence is the essential first step. At a minimum, undertake a comprehensive review of the offering materials, understand the business of the offeror, learn the qualifications and experience of the principals of the offeror, and know the risks associated with the investment. Additionally, verify that the representations in the offering materials are consistent with the information learned during the due diligence process.

Periodically update the information, as circumstances of offerors frequently change. Be sure the information you are providing to your clients reflects the current circumstances of the offeror.

FINRA will take a dim view of offerings in which there is only a single source of due diligence information, where the due diligence was paid for by the offeror, or where sales commissions are inordinately high. These conflicts of interest are red flags which, fair or not, give rise to unfavorable assumptions by regulators and arbitrators that are sometimes quite difficult to overcome. What might otherwise be a perfectly legitimate offering can be rendered suspect by these apparent conflicts.

While the due diligence process is essential for ensuring selection of appropriate investments for clients, the process will have been in vain if the broker/dealer is unable to demonstrate to regulators or arbitrators in arbitrations the extent of the due diligence. The most effective way to demonstrate your efforts in subsequent proceedings is to document them. Without documentary evidence, your defense counsel will have a much more challenging time persuading fact finders that the due diligence was adequate.

Next, determine the types of investors for whom the investment might be suitable. FINRA's normal suitability rule applies equally to private placements and traditional investment products. Generally, private placements will be considered speculative, and only those investors with a demonstrated tolerance for such risk should be considered. In some instances, private placements may be offered only to accredited investors, and the broker/dealer will be expected to know the circumstances and to qualify the investors. In addition, avoid over concentration of the investment in a portfolio. In all but the most unusual cases, private placements should make up a small portion of any individual investor's portfolio.

The risks of each particular investment must be disclosed to the investor. In addition to the risk of loss of principal, liquidity risk and restrictions on resale must be plainly disclosed. The offering documents should thoroughly describe the relevant risks and must be signed by the investor. This will provide the best evidence (to sometimes skeptical regulators and arbitrators) that the disclosures were actually made.

One fundamental step that is overlooked with surprising frequency is the completion of all offering documents by the investor. Recommendations are much easier to defend when the documentation is complete and accurate (and even more persuasive when completed in the handwriting of the investor, rather than the registered rep). If information is missing, it is harder to convince anyone that you had sufficient information to make a suitability determination, or that you were thorough in your presentation of the investment.

Finally, written supervisory procedures regarding the sale of private placements must be developed. Without WSPs, it is difficult to convince a regulator that reasonable supervision occurred. Likewise, regulators will want to know the extent of training of registered reps by the broker/dealer on the features, risks, and suitability of a particular offering. Again, documentation is key. In the world of litigation, "not documented" frequently means "not done."

¹ S. Hansard, Investment News, "FINRA to get tough on Reg D offerings," December 13, 2009.

If you are interested in purchasing coverage through the NAIFA endorsed Professional Liability Insurance Program, please call 1-800-247-3448.

*This information does not purport to be nor should be construed as legal advice and is not intended to replace professional/legal guidance on compliance issues that pertain to your organization. It is strongly suggested that you seek advice from recognized compliance experts and competent legal counsel, to advise about and determine your needs.

The NAIFA Professional Liability Insurance Program is administered by Affinity Insurance Services, Inc.; in CA, MN and OK, AIS Insurance Agency, Inc. (CA Insurance License #0795465) and in NY, AIS Affinity Insurance Agency.

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Risk Management