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FINRA Enforcement Action Stresses Procedures for Due Diligence on Private Placements of Investment Funds

Posted in Broker-Dealer Regulation, FINRA Enforcement

In a recent formal disciplinary proceeding, FINRA reaffirmed member firms’ obligations to maintain adequate procedures for conducting due diligence on private placements, including the review of sales materials, and systems for monitoring suitability.  Sunset Financial Services, Inc. (“Sunset”) sold private placements of investment funds as an unaffiliated broker-dealer under Regulation D of the Securities Act (“Reg D”).  The firm assigned responsibility for conducting due diligence on private placements, and for approving private placements for sale, to a vice president who was also responsible for reviewing third-party due diligence reports, formulating recommendations for private placements and monitoring the suitability of purchases of such private placements.

In 2004, the vice president approved the private placement of an investment fund that was operated by the son of a registered representative of Sunset.  Over the course of the next three years, the firm allegedly ignored red flags regarding the fund’s holdings and did not re-evaluate the appropriateness of retaining the fund on the firm’s approved list.  FINRA charged that the vice president also approved a second private investment fund operated by the same sponsor without considering issues raised about the first fund or reviewing third-party due diligence reports regarding the new fund.

FINRA found that the firm had inadequate procedures for due diligence on private placements and that checks and balances on the vice president’s activities were also inadequate since he was simultaneously recommending private placements and reviewing the suitability of those recommendations.

FINRA also found that the firm’s written supervisory procedures related to sales materials were inadequate.  Although the firm did not create its own sales materials, it allowed representatives to use sales materials created by fund sponsors, subject to pre-approval by the firm’s compliance department.  Sunset relied on its registered representatives to forward any sales materials to the compliance department for review.  FINRA said that the broker-dealer lacked a procedure to track the private placement materials received by registered representatives or to ensure that they were not passed on to customers prior to compliance review.

FINRA reminded member firms that they have a duty to conduct a reasonable investigation concerning securities offered under Reg D—including private funds—and the issuer’s representations about such securities.  Failure to comply with this duty can constitute a violation of the anti-fraud provisions of the federal securities laws.  Member firms should also carefully consider their suitability obligations.  Although the approach to due diligence and suitability evaluations will differ depending on the specifics of each Reg D offering, member firms are advised to review the sample checklist included in FINRA Regulatory Notice 10-22 as a starting point.

As we move into a new era of general solicitation for private placements, FINRA member firms should carefully consider their obligations under FINRA rules and the anti-fraud provisions of the federal securities laws and ensure that their supervisory procedures are updated to address their due diligence obligations and their oversight of sales materials provided to their customers.  For more information, see our client alert, “FINRA Actions and the Due Diligence Obligations of Broker-Dealers in Private Placements.”