Disclosure, Risk and Conflicts

Fair and balanced

The standard comes from FINRA Rule 2210(d) and applies to every communication with a customer, spoken or written: communications must be based on principles of fair dealing and good faith, must be fair and balanced, and must provide a sound basis for evaluating the facts. No false, exaggerated, unwarranted, promissory or misleading statement or claim. No omission of material information that would make the communication misleading.

In practice, three failures recur.

RISK RELEGATION. The benefits are described in conversation and the risks are left to the private placement memorandum. That is not balance. If a risk is material to the customer's decision, it belongs in the conversation where the recommendation is made.

PROJECTION. The issuer's target return, expected multiple or projected IRR is repeated as though it were a characteristic of the security. Rule 2210 forbids predicting or projecting performance, and a projection prepared by the issuer does not become permissible because someone else wrote it.

CERTAINTY LANGUAGE. "Guaranteed," "can't lose," "fully secured," "we expect to exit in three years." Each converts an uncertain outcome into a promise.

There is also a specific representation that is always false about a private placement: any suggestion that it has been reviewed, cleared or approved by the SEC or by a state regulator. It has not. Filing a Form D is a notice, not an approval, and neither is a Rule 5123 filing with FINRA.

The content outline also lists the requirement to "furnish most recent report of the firm's financial condition," which is FINRA Rule 2261. A member must make available for inspection by any bona fide regular customer, on request, the information about its financial condition disclosed in its MOST RECENT BALANCE SHEET, prepared in accordance with its usual accounting practices or with the requirements of state or federal securities law. It may be delivered on paper or, with the customer's consent, electronically. A customer for this purpose is any person who in the regular course of the member's business has cash or securities in the member's possession.

The risks a private security carries

The content outline names purchasing power risk explicitly and asks about risk in the construction of a portfolio. Here are the categories that matter, with the private placement gloss on each.

PURCHASING POWER RISK, also called inflation risk, is the risk that inflation erodes the real value of income and principal. The outline asks specifically about "its effect on the constant dollar value of income and principal in different types of investments." It is the risk that most damages fixed-income instruments, because a fixed coupon and a fixed principal repayment buy less each year. Equity has historically been the partial hedge, which is why the outline pairs a balanced portfolio of bonds, preferred, common and convertible issues with downside protection and an inflation hedge.

BUSINESS AND CREDIT RISK is the risk the issuer fails. For a private issuer this is the dominant risk, and it is not diversifiable within the position — you own one company.

LIQUIDITY or MARKETABILITY RISK is the risk of being unable to sell at all, or of selling only at a substantial discount. In a private placement it is not a tail risk. It is the normal condition. There is no market, the securities are restricted under Rule 502(d), and Rule 144 supplies a holding period rather than a buyer.

MARKET RISK is the risk of a general decline in asset values. It reaches private companies indirectly, through their ability to raise the next round and through exit valuations.

DILUTION RISK deserves naming because it is specific to this asset class. A later financing round on better terms can substantially reduce an early investor's proportionate ownership and economics, and preferred structures with liquidation preferences and participation rights can leave common holders with little in a modest exit. Dilution is disclosed in the capitalisation table of the PPM, and most retail investors will not read a cap table unaided.

LEGISLATIVE and REGULATORY RISK is the risk that a change in law alters the investment's economics — acute for issuers whose business depends on a regulatory regime or a tax treatment.

And the risk the outline builds into its own phrasing: the risk of holding. A concentrated speculative position requires the ability to hold during market fluctuations. An investor forced to sell at the wrong moment realises a loss the position did not require them to take — except in a private placement, where they may not be able to sell at all.

Portfolio characteristics as disclosure topics

Function 3.3 lists four characteristics of securities held in a portfolio, framed as things whose implications a customer must understand. They are worth taking in order.

MARKETABILITY. Whether and how quickly a holding can be converted to cash, matched against the customer's liquidity needs. The disclosure is not "these securities are illiquid." It is what illiquidity means in this case: no public market, transfer restrictions in the subscription agreement, issuer consent possibly required for transfer, and no defined exit date.

TAXABILITY. The tax treatment of holdings against the customer's bracket. Private offerings are often structured as partnerships or LLCs taxed as partnerships, which means a Schedule K-1 rather than a 1099, income allocated whether or not cash was distributed, potential state filing obligations wherever the entity operates, and unrelated business taxable income issues if the investment is held in a retirement account. A customer whose tax return becomes materially more complicated should have been told before subscribing, not in March.

CALLABILITY. Whether the issuer may redeem the security early, and the importance of call protection to a customer whose objective is income. A callable instrument is called when it suits the issuer, which is generally when rates have fallen and the investor would least like to reinvest.

CONVERTIBILITY. The value of a conversion feature and the effect of a potential FORCED conversion on the customer's objectives. Convertible preferred is the standard private-company instrument, and forced or mandatory conversion on a qualified financing or an exit is a normal term. A customer holding convertible preferred for its liquidation preference and dividend needs to understand that the preference can disappear on conversion.

The outline also asks about the appropriate mix of maturity schedules on debt obligations derived from the customer's ability to risk loss of principal and income — the standard laddering point, which applies to private debt as much as public.

Conflicts of interest

Regulation Best Interest requires full and fair written disclosure of all material facts relating to conflicts of interest associated with a recommendation, and requires the firm to have policies that identify and disclose, mitigate, or eliminate them. Private placements generate more conflicts per transaction than almost anything else a representative sells.

PLACEMENT COMPENSATION. The firm is paid by the issuer, out of the investor's money, for selling this security. That is the structural conflict and it is disclosable in amount and in kind.

EQUITY COMPENSATION. Where the agent takes warrants or shares, its interest is aligned with the issuer's valuation rather than with the customer's outcome.

AFFILIATION. Where the issuer is the member itself or a control entity, FINRA Rule 5122 applies and the conflict is at its maximum. Where a principal of the firm sits on the issuer's board, or the firm or its people have invested personally, that is material.

MATERIAL LIMITATIONS. A firm that offers only its own placements, or only a narrow shelf of them, must disclose that limitation and prevent it from skewing recommendations. This is expressly part of the conflict of interest obligation.

DIFFERENTIAL COMPENSATION. Where one offering pays the representative more than another, that creates an incentive that must be identified and MITIGATED, not merely disclosed. And any sales contest, quota, bonus or non-cash compensation based on the sale of specific securities or types of securities within a limited period must be ELIMINATED.

Disclosure is delivered in three places and they do different jobs. Form CRS gives the relationship summary. The firm's Regulation Best Interest disclosure document gives the standing conflicts and fee structures. The PPM gives the offering-specific conflicts. A conflict specific to this recommendation that appears in none of them has not been disclosed.

Two related rules complete the picture. FINRA Rule 2121 requires fair prices and commissions considering all relevant circumstances, and Rule 2122 requires charges for services to be reasonable and not unfairly discriminatory among customers. And FINRA Rule 5240 prohibits any attempt to coordinate prices, quotations or trading with another member, or to intimidate or threaten another member to influence a quotation or trade — the anti-intimidation rule the content outline lists under Function 3.2.