Due Diligence and the Private Placement Memorandum

Where the duty comes from

Nothing in Regulation D requires a broker-dealer to investigate anything. The duty comes from elsewhere, and FINRA set it out at length in Regulatory Notice 10-22, which remains the reference document for private placement due diligence.

The foundation is the antifraud law. When a broker-dealer recommends a security, it makes an implied representation that a reasonable investigation has been made. That principle comes from Hanly v. SEC, decided by the Second Circuit in 1969, which held that a broker-dealer recommending a security is under a duty to conduct a reasonable investigation concerning it.

Because the duty is grounded in the implied representation, a failure to investigate is charged as fraud rather than as a technical rule breach. FINRA names the provisions: Securities Act Section 17(a), Exchange Act Section 10(b) and Rule 10b-5, and FINRA Rules 2010 and 2020 — just and equitable principles of trade, and the prohibition on manipulative and fraudulent devices.

The scope of the required investigation is not fixed. Courts have said it depends on "the nature of the recommendation, the role of the broker in the transaction, its knowledge of and relationship to the issuer, and the size and stability of the issuer." A firm acting as placement agent for a start-up owes more than a firm executing an unsolicited order for a seasoned institution.

And the duty is heightened where it matters most. FINRA quotes the standard that in financing new speculative ventures, a broker-dealer "must be particularly careful in verifying the issuer's obviously self-serving statements." Private placements are, definitionally, mostly new speculative ventures.

What a reasonable investigation covers

Regulatory Notice 10-22 enumerates the areas of inquiry, and they are worth learning as a list because the exam treats them as one.

The ISSUER AND ITS MANAGEMENT. History and background of the company, its governing documents, historical financial statements and audit reports, internal controls, references from customers and suppliers, material contracts, prior securities offerings, litigation and regulatory problems, and the expertise, background and compensation of management.

The BUSINESS PROSPECTS. The viability of any patent or technology, industry conditions, the issuer's competitive position, the business plan, and — importantly — the assumptions underlying any financial model or projection. A projection is only as good as its assumptions, and checking the assumptions rather than the arithmetic is the work.

The ASSETS. For an issuer whose value is in physical property, this means site visits and inspection of the facilities, and third-party expert reports where the assets are geological or engineering in nature. FINRA is explicit that for oil, gas and mineral programs an independent expert opinion is expected.

The CLAIMS BEING MADE. Independent verification of the representations in the offering documents. Not confirmation from the person who wrote them.

The INTENDED USE OF PROCEEDS. Whether the money is actually allocated to the business objectives described, and whether the amount being raised is consistent with them.

FINRA is direct about what will not do. A broker-dealer may not "rely on the information provided by the issuer and its counsel in lieu of conducting its own reasonable investigation." A due diligence report commissioned by the issuer is a starting point, not an answer. The investigation must be the firm's own.

Red flags

The red-flag doctrine is the part of Notice 10-22 that decides most enforcement cases, and it is elegantly simple.

A broker-dealer must note any information it encounters "that could be considered a red flag that would alert a prudent person to conduct further inquiry." Having encountered one, the firm must follow it. And where red flags are present, the firm "must do more than simply rely upon representations by issuer's management, the disclosure in an offering document or even a due diligence report."

The consequence is that a red flag raises the standard rather than merely adding a task. The Kunz and Cline matter, which FINRA cites, made this concrete: brokers could not rely on audited financial statements when other information indicated those statements were inaccurate. An audit opinion is evidence, not immunity.

One particular red flag is worth naming, because it is the one representatives most often talk themselves past: an issuer's refusal to provide information the firm has asked for is itself a red flag. A firm that asks for the bank statements, is told they are not available, and proceeds anyway has not conducted a reasonable investigation. It has conducted one and ignored the result.

Examples that recur in enforcement: financial statements that are unaudited when they could have been audited; a use-of-proceeds section that is vague or that routes significant money to insiders; management with undisclosed regulatory history; projections with no stated assumptions; an issuer that has failed to make required filings on earlier offerings; related-party transactions on terms nobody would offer a stranger; and an auditor or counsel that has recently resigned.

The practical test is not whether you found fraud. It is whether a prudent person, seeing what you saw, would have asked another question — and whether you asked it.

The private placement memorandum

The private placement memorandum, or PPM, is the offering document. In a Rule 506(b) offering with non-accredited purchasers it is how the issuer discharges the Rule 502(b) information requirement. In an all-accredited offering there is no rule requiring one at all — and issuers produce them anyway, because the antifraud provisions do not care whether disclosure was mandatory.

A PPM typically contains the terms of the offering; a description of the issuer's business, its history and its market; risk factors; management biographies; the capitalisation table and dilution analysis; the use of proceeds; historical financial statements; a description of the securities being offered and the rights attaching to them; the compensation payable to the placement agent; related-party transactions and conflicts of interest; the tax consequences; and the transfer restrictions.

Three sections deserve a representative's attention above the others.

RISK FACTORS, because they are what makes disclosure adequate and because they are the section a customer is least likely to read. If the risk actually materialises and it was disclosed in terms the customer could understand, the firm's position is strong. If it was buried, it was not disclosed.

USE OF PROCEEDS, because it is where an offering's honesty is most visible, and because FINRA lists it as its own area of inquiry.

CONFLICTS OF INTEREST, because they include your firm's compensation, and because Regulation Best Interest gives that disclosure independent force.

A PPM is not a prospectus and must not be described as one. It is not reviewed, cleared or approved by the SEC or by any state, and a PPM that implies otherwise is itself a violation. Note also that a PPM used to promote a private placement is one of the documents FINRA Rule 5123 requires a member to file, which lesson 3.4 covers.

Finally, the PPM is the issuer's document, drafted by the issuer's counsel. Reviewing it is a step in due diligence. It is not the due diligence.

Sophistication does not shrink the duty

The most commercially dangerous belief in this business is that selling only to accredited investors reduces what the firm owes.

FINRA addresses it head on. "The fact that a BD's customers may be sophisticated and knowledgeable does not obviate the duty to investigate." Meeting a net worth threshold does not remove the need for a full suitability analysis, and the firm must have a basis for believing the customer understands the risks and can bear them.

The reasoning is straightforward once stated. Accreditation is a proxy for the ability to absorb a loss and to access information. It is not evidence that this particular investor has been given accurate information about this particular issuer. The whole of the antifraud law continues to apply to a sale to the wealthiest possible buyer.

There is a second and subtler point in Notice 10-22 that connects back to Rule 502(b). The SEC has advised that issuers should consider providing the same information to accredited investors as to non-accredited ones, in view of the antifraud provisions. The information requirement is switched off for accredited investors. The antifraud provisions never switch off. An offering that gives non-accredited purchasers a full PPM and accredited purchasers a two-page term sheet has arranged its disclosure exactly backwards from where its legal risk sits.

The due diligence file is also the firm's defence. Section 12(a)(2), from lesson 2.1, gives a seller the defence that it did not know of the misstatement and could not have known it in the exercise of reasonable care — and puts the burden of proving that on the seller. The record of what the firm asked, what it was told, what it verified independently and what it did about the answers is what discharges that burden. A firm that did good work and did not write it down is in the same position as a firm that did nothing.