THE RECURRING DUE DILIGENCE FAILURES WITH PRIVATE OFFERINGS

FINRA Sanctions Eight More Firms.  FINRA’S  recent announcement that it had sanctioned eight more firms and 10 individuals, and ordered restitution totaling more than $3.2 million, for selling interests in private placement offerings without having a reasonable basis for recommending the securities is yet another warning to firms that fail to conduct adequate due diligence on alternative investment products.

NASD Conduct Rule 2310 requires member firms, when making a recommendation to a customer to purchase or sell a security, to have reasonable grounds to believe that the recommendation is suitable for the customer.  What this means, under FINRA rules, is that member firms who sell alternative investments such as Regulation D offerings must be able to demonstrate that they have an understanding of the potential risks and rewards of the security.  That demonstration must go beyond simply reading prospectuses, private placement memoranda, and other scripts passed along from issuers or participants in the offering process.

The eight firms and their reps FINRA snctioned sold interests in several high-risk private placements, including those issued by Provident Royalties, LLC, Medical Capital Holdings, Inc. and DBSI, Inc., which ultimately failed, causing significant investor losses.  The oft-forgotten message FINRA makes with these cases is that firms have at least two continuing responsibilities with alternative securities offerings.  The first is that member firms need first to document for themselves, and convey to their clients, an understanding of the inherent risks of private offerings; and the second is, after doing so, ask themselves whether these products are suitable for their customers.  Failing to conduct adequate due diligence makes this impossible to do since a selling firm may have no reasonable grounds to believe that the Regulation D offfering is suitable for any customer.

As with these cases, FINRA has shown no reservation in imposing supervisory liability , under Rule 3010, on principals of these firms for failing to conduct meaningful due diligence prior to approving such offerings for sale to customers.

Author: Dexter Johnson

The author is a an attorney who for the past 14 years has concentrated his practice in representing, successfully, investment advisers, broker-dealers, corporations and individuals who are subject to SEC, FINRA, State or other regulations and who may be the subject of regulatory examination, review or investigation. He formerly worked at the SEC. His regulatory and litigation experience has encompassed virtually every type of securities issue in the industry. He has also negotiated favorable outcomes in many of these matters for his clients.