INSIGHT: FINRA Advertising Rules Apply to Private Placements

The Financial Industry Regulatory Authority (FINRA) has published a notice on private placement advertisements and it’s a humdinger.

In Regulatory Notice 20-21 the front-line regulator for the brokerage industry laid out key principles that every broker-dealer should take to heart. Firms need to ensure that private placement sales material complies with FINRA Rule 2210, FINRA’s advertising rule, whether it was prepared by the issuer, by another third party or by the broker-dealer itself.

Broker-dealers must ensure that claims about the benefits of an investment are balanced with disclosure about the risks. Forecasts must be reasonable and must disclose the assumptions upon which they are based, and distribution rates must be used with caution. The release is particularly impressive when it skillfully explains the pitfalls of internal rates of return.

All Retail Investors Deserve FINRA-Level Protection

Alas, the notice reminds us that most of the retail private placement market is scarcely regulated. FINRA states that of the 20,000 new Reg D filings filed with the SEC each year, only about 2,000 are also filed with FINRA.

It is a pity that the SEC’s data concerning the private placement market is so woefully inadequate. For example, the SEC’s data doesn’t tell us how many of these 20,000 private placements are made to retail investors rather than to institutions or what types of intermediary participated other than broker-dealers.

Nevertheless, the numbers imply that most retail investors buy directly from an issuer who is neither regulated by FINRA nor regularly examined the SEC. These investors lack the protection that broker-dealer customers receive. The SEC should either afford equal protection to all retail investors, or make distribution through a FINRA-regulated broker-dealer a condition of Reg D.

Broker-Dealers Should Apply the Advertising Rules to PPMs

The notice teaches a second lesson, one for compliance departments. The notice distinguishes a “retail communication” from a “private placement memorandum.” The notice says that a broker-dealer that “assists in the preparation of a private placement memorandum” should expect that the private placement memorandum (PPM) is subject to the advertising rule, Rule 2210. The notice implies that while Rule 2210 applies to all retail communications used by a broker-dealer, it applies only to a PPM prepared by a broker-dealer.

A prudent compliance department would apply the key principles of Rule 2210 to any PPM, including one that the broker-dealer did not prepare. A careful broker-dealer should not distribute any deal for which the PPM does not comply with the key provisions of Rule 2210.

There are at least five reasons to be so cautious.

• First, avoiding such a private placement is the ethical path to take. A broker-dealer should not distribute a PPM that lacks adequate risk disclosure or exaggerates the potential benefits of the investment, for example.
• Second, the antifraud provisions of the federal securities laws apply to PPMs and the broker-dealer could be held liable under the antifraud provisions for an issuer-prepared PPM that it distributes. If the PPM complies with the key principles of Rule 2210 then the broker-dealer can be more confident that it does not violate the antifraud provisions.
• Third, federal law does not define “private placement memorandum.” Some so-called “private placement memoranda” look like advertisements. A broker might believe that she is handing over a PPM to the retail customer. Her FINRA examiner might consider the document to be a retail communication and might write up the broker-dealer if the document doesn’t comply with Rule 2210.
• Fourth, the broker-dealer might have assisted in the preparation of the PPM. FINRA does not explain the circumstances under which a broker-dealer has given the requisite assistance. Conduct less participatory than acting as the lone draftsman probably would be enough. If a FINRA examiner decides that the broker-dealer has assisted in the preparation of a defective PPM then he might write up the broker-dealer for violating Rule 2210.
• Fifth, distributing a defective PPM might excite the interest of FINRA’s Corporate Financing Department. FINRA Rule 5123 requires broker-dealers to file PPMs for most retail private placements in which they participate. The Department is particularly interested in whether the broker-dealer conducted a reasonable investigation of the recommended deal. A broker-dealer using a PPM that, for example, forecasts unrealistic revenues, misleadingly advertises a distribution rates, or claims an internal rate of return based upon unrealistic assumptions, invites a thorny question from the Corporate Finance Department: Did you understand the deal that you were selling? If not, then the broker-dealer might have violated the Care Obligation of Regulation Best Interest, which requires the broker-dealer to “understand the potential risks, rewards, and costs associated with the recommendation.”

Only distribute a private placement when the PPM complies with the key principles of Rule 2210.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Thomas M. Selman is the founder of Scopus Financial Group, providing regulatory guidance to broker-dealers. Until January 2020, Selman served as FINRA’s executive vice president for regulatory policy and its legal compliance officer.