FINRA Issues Reminder With Respect to the Obligations of Broker-Dealers in Regulation D Offerings

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 suitability requirements.

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 recommended.

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:

  • 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 determination.

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.

Investigation Practices

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.