FINRA Regulatory Notice 23-08: Building on Regulatory Notice 10-22 to Develop More Robust Due Diligence of Private Placement Offerings

by Jacob Heidkamp

FINRA recently released Regulatory Notice 23-08, which provides a reminder to FINRA members of their reasonable investigation obligations when selling private placement investments to their clients under Regulation D. The Regulatory Notice marks FINRA’s first substantial discussion of due diligence related to private offerings since Regulatory Notice 10-22, which was released in April 2010, and forms a crucial part of the foundation of broker-dealer due diligence practices in satisfying their reasonable investigation requirements for offering private placement investment opportunities for their clients. While Regulatory Notice 23-08 does not create new legal or regulatory requirements or new interpretations of existing regulations, the notice does identify areas for consideration and focus for FINRA members in establishing new or modifying existing practices, based on certain observations and examples that FINRA has included in the Regulatory Notice 23-08. In this blog, we will explore some of these areas of focus and some practical steps broker-dealers can take to enhance their due diligence practices based on areas identified in Regulatory Notice 23-08.

Conducting a Reasonable Investigation under 10-22

Let’s start with a quick refresher on broker-dealer private placement due diligence obligations under Regulatory Notice 10-22 and the scope of a reasonable investigation. First, it is important to note that a reasonable investigation is not a one-size fits all approach, and what constitutes a reasonable investigation into a specific securities offering will depend on the facts and circumstances of each offering. The scope of the reasonable investigation is also guided by the nature of the recommendation from the broker-dealer, their role in the transaction, and the size and stability of the issuer. Case law guides, and FINRA highlights, that particular attention should be paid to securities issued by smaller companies of recent origin. Regulatory Notice 10-22 also identifies certain specific areas of focus that a broker-dealer must conduct a reasonable investigation into, including:

  1. The issuer and its management.
  2. The business prospects of the issuer.
  3. The assets held by or to be acquired by the issuer.
  4. The claims (by the issuer’s management) being made; and
  5. The intended use of proceeds of the offering.

10-22 also notes that a broker-dealer must note any “red flag” that would alert a prudent person to conduct further inquiry. The concept of red flags is expansive and difficult to pin down in a bright-line analysis. However, red flags may include an issuer’s financial position, litigation and regulatory concerns, prior performance issues, affiliated transactions, and a lack of furnishing relevant information and answers to follow-up on questions related to an offering, among others. It is important to note that in the presence of red flags, the broker-dealer must do more than rely on representations from management or its counsel and that independent investigation of these matters is critical.

Key Takeaways from NTM 23-08

Now let’s examine NTM 23-08 and some key takeaways. Based on FINRA cycle examinations and disciplinary actions, FINRA identifies the following areas as critical for broker-dealers in meeting their reasonable investigation obligations for a private placement offering:

  1. Regulatory and litigation history of the issuer and its management.
  2. New material developments involving the issuer.
  3. Affiliated transactions between the issuer and affiliates
  4. Representations of past performance by the issuer, its sponsor, or its manager

These identified topics from both 10-22 and 23-08 are all critical areas of inquiry into any investment manager and individual securities offering. FactRight’s due diligence reporting is specifically designed to support broker-dealers’ reasonable investigation efforts with these areas of focus at the forefront. Our research and due diligence reports delve into identifying the existence of any of these matters and into providing analysis and evaluate context on any identified areas that may color whether such matters are red flags in a deal or if mitigating circumstances may reduce the risks associated with any of these topics.

With respect to regulatory and litigation history, all of our offering and sponsor reports include a thorough legal and regulatory analysis, with background checks on key individuals and entities, designed to identify any concerns regarding how the issuer conducts its business, any disqualifying “bad actor events,” and areas of litigation that may impact an issuers financial position or management’s ability to support its investment programs. Additionally, the emphasis on new material developments puts into focus the necessity of conducting regular updates on sponsor operational due diligence reports for investment program sponsors.

Analyzing the substance of affiliated transactions is key in understanding whether such transactions create material conflicts of interest amongst the issuer, the management team, and various groups of investors. For additional information on affiliated transactions and how we think through these transactions and conflicts of interest, please reference Due Diligence Considerations: The Continuum of Conflicts of Interest to Alignment of Interests, authored by FactRight’s Julie Olsen.

Ultimately, an assessment of an investment sponsor’s track record is about answering the question, has the sponsor done what they said they would do? This straightforward inquiry sounds like it should inspire an equally simple answer. Unfortunately, gleaning accurate and reliable prior performance information from sponsors often proves difficult because investment managers choose how to present their track record in the best light. Our operational due diligence reports focus on a sponsor’s prior performance to evaluate the numbers and understand what has or hasn’t worked in the past. For additional information, check out Part I and Part II of this article addressing how to effectively assess a sponsor’s prior performance, authored by FactRight’s Kemp Hanley.

How to Demonstrate Reasonable Investigation

NTM 23-08 also identifies ways in which a FINRA member may demonstrate they have conducted a reasonable, independent investigation, including:

  1. Documenting the inquiries, research, and analysis conducted.
  2. Obtaining additional information, including primary documents, from the issuer.
  3. Critically analyzing third-party due diligence reports.

Documenting Inquiries, Research and Analysis, and Obtaining Additional Information

FactRight due diligence reports are designed to assist broker-dealers and RIAs with their research into issuers by clearly identifying the documents and materials reviewed, meetings and discussions with management, and transparently identifying critical assumptions related to the analysis of an offering. Our due diligence begins with a request for information, including organizational and offering documents, and a preliminary discussion with members of the management of the issuer. Analysis of initially provided documents and the preliminary management discussion leads to additional requests for supporting documents, including material contracts, valuation reports, and other documents. This process ensures that wealth managers understand our research’s foundation and allow the report reader to efficiently request and obtain information from the issuer that we have reviewed to allow for additional evaluation and follow-up as needed by the broker-dealer or RIA.

Use of Third-Party Due Diligence Reports

NTM 23-08 highlights the use of third-party due diligence reports, including those produced by FactRight and other providers. NTM 23-08 notes that broker-dealers must critically evaluate 3rd party reports, including the independence, incentives, and qualifications of the party providing the report.  FINRA guides that if a third-party report has inconsistencies or inadequately addresses areas of concern, then the FINRA member should follow up with the source of the report or by independently researching the matter. NTM 23-08 footnote 42 cites case law noting that a broker-dealer failed to conduct a reasonable investigation of a private offering by relying on a third-party report that included “no independent assessment or any substantive analysis of the issuer” or what is known in the industry as “PPM regurgitation.” Analysis in FactRight reports covers key areas, including the evaluation of existing portfolio assets, including independent site inspections, stress testing financial projections, distribution sustainability analysis, and an overview of debt terms and interest coverage ratios, among other areas. FactRight reports feature additional analysis and context related to benchmarking fee structures with other similar private offerings as well as evaluating key offering terms and governance provisions to identify any atypical provisions that may limit investor transparency and governance participation or present additional risks to investors. It is important to understand that while third-party diligence may play a key role in evaluating investment managers and individual securities offerings, it is not a silver bullet in satisfying the wealth managers’ reasonable investigation requirements. The proper use of a third-party due diligence report is as a supplement to the wealth manager’s own reasonable investigation of a private offering. Third-party reports and engagement with third-party personnel can be key components to amplify your own research bandwidth.

Timeline to Conduct Due Diligence

NTM 23-08 also highlights the need for adequate time to conduct due diligence. The notice highlights that “it may raise a concern” if participation in a given offering is predicated on a prospective selling member’s approval of an offering on a timetable that does not allow for sufficient time to complete a reasonable investigation.  We heartily agree with this cautionary notice, and this is especially topical for anyone knowledgeable about the robust capital raising in late 2022 in the syndicated 1031 market. While standardized offering terms from one offering to the next may streamline the diligence process from an organizational analysis perspective, undoubtedly, detailed analysis of individual real estate property or properties in a portfolio requires a certain level of time to complete.  

One best practice that we find many wealth managers that utilize our reports engage in is that they include a paper copy of the due diligence report that is inclusive of notes detailing the readers’ follow-up related to risk factors or “red flags” identified in our due diligence reports. Courts have determined that failure to conduct a reasonable investigation may amount to “recklessness” under the anti-fraud provisions of the securities laws, and therefore ensuring a documentary record that your broker-dealer has performed a reasonable investigation is paramount to the successful vetting of private offerings from both a research and compliance perspective. Including a copy of the due diligence report with notes and any supplementary follow-up conducted in your research file is a simple and efficient way to optimize your diligence procedures to ensure that you’re executing your reasonable investigation requirements.

Due Diligence Support Going Forward

In conclusion, while NTM 23-08 does not create any additional due diligence obligations for broker-dealers in offering private placements, the notice identifies key areas of focus to help bolster the due diligence of any wealth manager engaged in private offerings. At FactRight, our team of analysts welcomes your questions, and we are always glad to discuss the contents of our due diligence reports with our audience of wealth managers. Interacting with our broker-dealer and RIA clients has been a critical part of the evolution of our work product to ensure that we provide valuable insight into the diligence of private and public alternative investment offerings.