On May 9, 2023, the Financial Industry Regulatory Authority, Inc. ("FINRA") issued Regulatory Notice 23-08 (the "Notice"), which provides supplemental and updated guidance for members conducting private placements pursuant to the Regulation D safe harbors under Sections 3 or 4 of the Securities Act of 1933, as amended.
The Notice does not change existing laws, regulations or interpretations of existing regulatory requirements. Rather, the Notice was provided as a reminder of members' obligations in light of changes in the legal and regulatory framework since FINRA published Regulatory Notice 10-22 in 2010 (the "2010 FINRA Notice").
Since passage of the Jumpstart Our Business Startups Act of 2012, Congress and the Securities and Exchange Commission (the "SEC") have reduced many of the barriers to exempt offerings. Perhaps as a result, there has been significant increased reliance on private placements rather than registered offerings for capital raising. According to the SEC's Division of Economic and Risk Analysis, between July 1, 2021 and June 30, 2022, for example, the total raised in registered offerings was just over $1.1 trillion, while, by contrast, the total raised through private offerings was $4.3 trillion. The Notice notes that while these changes have increased funding opportunities for issuers and investment options for investors, private offerings may present certain risks to investors.
Regulation Best Interest
The SEC adopted Regulation Best Interest ("Regulation BI") in 2019, well after the 2010 FINRA Notice. Regulation BI generally requires a broker-dealer or associated person thereof, when recommending any securities transaction or investment strategy involving securities (including account recommendations) to a retail customer, to act in the best interest of the retail customer without placing the financial or other interest of the broker-dealer or associated person ahead of the interest of the retail customer. In order to meet this requirement, Regulation BI contains four specified component obligations: the Care Obligation; the Disclosure Obligation; the Conflict of Interest Obligation; and the Compliance Obligation.
The Notice provides guidance on how to satisfy the Care Obligation of Regulation BI, highlighting the obligation of reasonable investigation and considering factors in making a recommendation that exceed those in FINRA's suitability rule, FINRA Rule 2111. A more detailed chart summarizing the requirements under Regulation BI and the guidance provided by FINRA in the Notice is attached as Appendix A.
Reasonable Investigation. Pursuant to Regulation BI, when making a recommendation to a retail customer, broker-dealers and their associated persons must exercise reasonable diligence, care and skill to understand the potential risks, rewards and costs associated with the recommendation, and must have a reasonable basis to believe that the recommendation could be in the best interest of at least some retail customers. To meet this reasonable basis obligation, a broker-dealer or associated person must conduct a reasonable investigation of any security or investment strategy involving a security it recommends. What constitutes a reasonable investigation depends on the facts and circumstances; however, according to FINRA, the presence of "red flags" should alert the broker-dealer/associated person to the need for further inquiry.
The 2010 FINRA Notice stated that a reasonable investigation should, at a minimum, include review of: (i) the issuer and its management; (ii) the business prospects of the issuer; (iii) the assets held by or to be acquired by the issuer; (iv) the claims being made; and (v) the intended use of proceeds of the offering. Based on FINRA's subsequent observations, the Notice advises that, as part of a reasonable investigation, broker-dealers should also consider addressing, where relevant, the following:
- Regulatory and litigation history of the issuer and its management, including the criminal, disciplinary, regulatory, and litigation history associated with the issuer, its management, and any affiliate that may be materially involved in the issuer's business, as well as the issuer's compliance with the bad actor provisions under Regulation D.
- New material developments, including events that are or should be reasonably known to the member during an offering, for example, when there are ongoing legal proceedings or regulatory inquiries involving the issuer.
- Transactions or payments between an issuer and the issuer's affiliates involving offering proceeds, including the terms of the transaction between the related parties and whether an arrangement presents a material conflict of interest for the issuer and, if so, the sufficiency of disclosure.
- Representations of past performance of the issuer, its sponsor, or its manager to identify any such representations which may be misleading or exclusively selected based on positive results. This is particularly important when the representations pertain to specific prior issuances.
The following are suggested steps to take to demonstrate that a broker-dealer has conducted a reasonable, independent investigation:
- Maintain an updated due diligence file documenting both the process and results of the inquiries, research, and analysis conducted.
- Perform an independent analysis of issuer representations and
claims, which may require obtaining additional documentation from
- For example: if a representation includes material contracts or permits, a reasonable review may include reviewing the enumerated contacts and permits.
- Critically analyze any diligence reports provided by third parties engaged to perform diligence, such as appraisers, attorneys or due diligence experts. If the third party is engaged by the broker-dealer or issuer, the broker-dealer should consider the independence, incentives and qualifications of the third party.
- Adequately address any red flags prior to recommending the offering.
- Apply a heightened analysis when recommending an investment that involves complex features or unique benefits to investors.
Customer-Specific Obligation. Broker-dealers and associated persons must exercise reasonable diligence, care and skill to have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on that retail customer's investment profile and the potential risks, rewards and costs associated with the recommendation and does not place the financial or other interest of the broker-dealer or associated person ahead of the interest of the retail customer.1 To satisfy the requirement, broker-dealers and their associated persons should:
- Obtain and analyze sufficient customer information to form a reasonable basis to state that the present recommendation is in the retail customer's best interest.
- If retail customer information is unavailable despite reasonable diligence, carefully consider whether they have a sufficient understanding of the retail customer to properly evaluate whether the recommendation is in the best interest of that retail customer.
- Consider "reasonably available alternatives" offered by the broker-dealer as part of having a "reasonable basis to believe" that the recommendation is in the best interest of the retail customer.
As noted in recent SEC staff guidance,2 broker-dealers and their associated persons should apply heightened scrutiny to whether a risky or complex product is in the retail customer's best interest. Information to consider when conducting a heightened review could include whether there are lower risk or less complex options available that would achieve the same result, and whether the retail customer "has an identified, investor-specific trading objective that is consistent with the product's description in its prospectus or offering documents, and/or has the ability to withstand heightened risk of financial loss." Importantly, broker-dealers/associated persons should consider whether lower risk or less complex options can achieve the same investment objectives.
The Disclosure Obligation requires a broker-dealer or associated person to provide in writing prior to, or at the time of the recommendation, full and fair disclosure of all material facts relating to the scope and terms of the relationship with the retail customer and all material facts relating to conflicts of interest that are associated with the recommendation. The Notice emphasizes that disclosure of conflicts of interests alone does not satisfy the obligation to act in the retail customer's best interest.
CONFLICTS OF INTEREST OBLIGATION
The Notice highlights the SEC staff's recent guidance in the SEC Staff Bulletin that evaluation and disclosure of conflicts pursuant to Regulation BI "should not be merely a 'check-the-box' exercise, but a robust, ongoing process that is tailored to each conflict." Notably, conflicts may be of particular concern when broker-dealers recommend to retail customers private placements of securities issued by an affiliated company. However, even where the securities are not issued by an affiliated company, conflicts can arise from a close relationship with the issuer, including when a broker-dealer engages in other activities for or with the issuer or when an associated person separately may be connected to the issuer. Moreover, the Notice states that there are conflicts inherent in any recommendation of securities, including private placements, based on the potential or actual receipt of compensation, revenue or other benefits (financial or otherwise) which must be addressed in accordance with the rule.
1. Regulation BI also imposes quantitative obligations. See SEC Rule 15l-1(a)(2)(ii)(C).
Visit us at mayerbrown.com
Mayer Brown is a global services provider comprising associated legal practices that are separate entities, including Mayer Brown LLP (Illinois, USA), Mayer Brown International LLP (England & Wales), Mayer Brown (a Hong Kong partnership) and Tauil & Chequer Advogados (a Brazilian law partnership) and non-legal service providers, which provide consultancy services (collectively, the "Mayer Brown Practices"). The Mayer Brown Practices are established in various jurisdictions and may be a legal person or a partnership. PK Wong & Nair LLC ("PKWN") is the constituent Singapore law practice of our licensed joint law venture in Singapore, Mayer Brown PK Wong & Nair Pte. Ltd. Details of the individual Mayer Brown Practices and PKWN can be found in the Legal Notices section of our website. "Mayer Brown" and the Mayer Brown logo are the trademarks of Mayer Brown.
© Copyright 2023. The Mayer Brown Practices. All rights reserved.
This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.