July 13, 2010
The Financial Industry Regulatory Authority (FINRA) recently issued a
regulatory notice discussing the obligation of broker-dealers (BD) to conduct
reasonable investigations in Regulation D offerings. Regulation D provides
exemption from the registration requirements under the Securities Act of 1933
but not from the antifraud provisions of the federal securities laws. As a
result, a BD has a duty to conduct a reasonable investigation of securities it
recommends, including those sold in a Regulation D offering. Moreover, a BD that
recommends securities offered under Regulation D must meet applicable
The Securities and Exchange Commission (SEC) and federal courts have long
held that a BD that recommends a security is under a duty to conduct a
reasonable investigation into that security and the issuer’s representations
about it. Failure to comply with this duty, including appropriate supervisory
procedures, can constitute a violation of the antifraud provisions of federal
securities laws and FINRA rules. The extent and nature of the investigation
depends, among other factors, upon the type of recommendation, the role of the
BD, the BD’s knowledge and relationship to the issuer and the size and stability
of the issuer. However, both the SEC and federal courts recognize that a more
thorough investigation is required for securities issued by smaller, newly
formed companies, including many Regulation D issuers.
NASD Rule 2310 requires that a BD have reasonable grounds to believe its
recommendation is suitable for the customer. This analysis has two components.
First, the “reasonable basis” suitability analysis requires the BD to have a
reasonable belief, based on a reasonable investigation, that the recommendation
is suitable for at least some investors.
Second, the “customer specific” suitability analysis requires that the BD
determine whether the security is suitable for the customer to whom it would be
In order to help ensure that it has fulfilled its reasonable basis
suitability responsibilities, a BD in a Regulation D obligations should, at a
minimum, conduct a reasonable investigation concerning:
- the issuer and its management;
- the business prospects of the issuer;
- the assets held by or to be acquired by the issuer;
- the claims being made; and
- the intended use of the proceeds of the offering.
To help satisfy its customer specific suitability analysis, the BD should
make reasonable efforts to gather and analyze the following information about
- the customer’s other holdings;
- financial situation and needs;
- tax status investment objectives; and
- such other information that would enable the BD to make its suitability
While the aforementioned lists are offered as a guideline, it is important
that each investigation be tailored to the specific offering in a manner that
ensures that it meets its regulatory responsibilities.
In general, a BD may not simply rely upon the issuer for information, nor may
it rely on the information provided by the issuer and its counsel in lieu of
conducting its own reasonable investigation. In the course of its investigation,
if the BD discovers that it lacks essential information about an issuer or its
securities when it makes its recommendation, the BD must disclose this fact as
well as the risks that arise from its lack of information.
During its investigation, a BD must note any information that could be
considered a “red flag.” A BD’s reasonable investigation responsibilities
require it to follow up on any red flags and investigate any substantial adverse
information about the issuer. When presented with red flags, the BD must do more
than rely upon representations by issuer’s management, the disclosure in an
offering document or a due diligence report of the issuer’s counsel.
Furthermore, an issuer’s refusal to provide a BD with the requested information
could itself constitute a red flag. Where an issuer is non-responsive, the BD
must determine whether sufficient information is otherwise available.
If a BD chooses to retain or rely upon counsel or other experts to assist it
in fulfilling its reasonable investigation obligation, it must carefully review
the qualifications and competency of the counsel or experts and ensure that all
gaps or omissions in their investigation are separately addressed by the BD. If
the BD relies upon a syndicate manager to conduct the investigation, the BD
should meet with the manager, obtain a description of the manager’s reasonable
investigation efforts, and ask questions of the manager concerning the
independence and thoroughness of the manager’s exercise of its responsibilities.
Throughout the investigation process, a BD should retain records documenting
both the process and the results of its investigation to demonstrate that it has
performed a reasonable investigation.
The Private Equity and Broker-Dealer Practice Groups at McGuireWoods LLP are
dedicated to keeping our clients advised of new legislative and business
developments as they occur. If you have any questions regarding these issues,
please feel free to contact Mark A. Kromkowski (312.849.8170), Anitra T. Cassas
(804.775.4727), Bryan P. Bylica (312.750.3617), your primary attorney at
McGuireWoods LLP or any of the authors.