A private placement is generally the offer or sale of unregistered securities that are not the subject of a registration statement filed with the United States Securities and Exchange Commission pursuant to the Securities Act of 1933.

As a general matter, a security is an investment of money, with the expectation of profits, solely from the efforts of others. Also, as a general matter the sale of unregistered securities is a crime, unless the sale is exempt under Sections 3(b) or 4(2) of the Securities Act of 1933, or Regulation D as promulgated thereunder.

The subject of a private placement is only limited by one’s imagination, and can include real estate, common stock, warrants, bonds, hedge fund interests, orange groves, timberland, tax liens, structured settlements, Ponzi schemes, or simply fraudulent promissory notes or promises to pay by your broker.

However, generally, to meet the requirement of the private placement exemptions under the Securities Act or Regulation D, depending upon the size of the offering, and the number of non-accredited investors, an issuer is required to make some form of disclosure regarding the nature, character and risk factors of the securities being offered. Depending upon these same factors, however, an issuer may not even be required to provide prospective investors with audited financial statements. However, while a private placement may be exempt from registration, it is nonetheless subject to the anti-fraud provisions of the federal securities laws.

In some cases however investors do not purchase private placements on their own initiative, investors are sold or recommended private placements by their stockbrokers or investment professionals, sometimes with, or most often without the knowledge or approval of their brokerage firm. In many cases, these brokerage firms are responsible for these unapproved activities under a variety of legal theories including vicarious liability as the agent or employee of the brokerage firm, as a control person of the broker, or based upon the brokerage firm’s failure to supervise the activities of its registered representatives or stockbrokers.

However, when the sale of a private placement is authorized or approved by the broker-dealer, the Financial Industry Regulatory Authority or FINRA has reminded its members that:

In the context of a Regulation D offering, Rule 2310 requires broker-dealers to conduct a suitability analysis when recommending securities to both accredited and non-accredited investors that will take into account the investors’ knowledge and experience. The fact that an investor meets the net worth or income test for being an accredited investor is only one factor to be considered in the course of a complete suitability analysis. The BD must make reasonable efforts to gather and analyze information about the customer’s other holdings, financial situation and needs, tax status, investment objectives and such other information that would enable the firm to make its suitability determination. A BD also must be satisfied that the customer “fully understands the risks involved and is…able…to take those risks.”

Failure to comply with this duty can constitute a violation of the anti-fraud provisions of the federal securities laws and, particularly, Section 17(a) of the Securities Act, Section 10(b) of the Securities Exchange Act and Rule 10b-5 thereunder. It also can constitute a violation of FINRA Rule 2010, requiring adherence to just and equitable principles of trade, and FINRA Rule 2020, prohibiting manipulative and fraudulent devices.

FINRA Notice to Members 10-22 also provides that a broker dealer must conduct a reasonable investigation into each offering, must maintain supervisory procedures under Rule 3010 that are reasonably designed to ensure that these securities are suitable for particular customers, and retain records documenting both the process and results of its investigation.

FINRA has also reminded its members that “In order to ensure that it has fulfilled its suitability responsibilities, a BD in a Regulation D offering should, at a minimum, conduct a reasonable investigation concerning:

  • the issuer and its management;
  • the business prospects of the issuer;
  • the assets held by or to be acquired by the issuer;
  • the claims being made; and
  • the intended use of proceeds of the offering.
  • A BD must conduct a reasonable investigation in connection with each offering, notwithstanding that a subsequent offering may be for the same issuer.”

Similarly, as the Securities & Exchange Commission, in its approval of the consolidated FINRA Suitability Rule recently observed: Reasonable-basis suitability requires a broker to have a reasonable basis to believe, based on reasonable diligence, that the recommendation is suitable for at least some investors.

In general, what constitutes reasonable diligence will vary depending on, among other things, the complexity of and risks associated with the security or investment strategy and the firm’s or associated person’s familiarity with the security or investment strategy.

A firm’s or associated person’s reasonable diligence must provide the firm or associated person with an understanding of the potential risks and rewards associated with the recommended security or strategy.

See Securities Exchange Act Release No. 63325.

Guiliano Law Group

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