The Financial Industry Regulatory Authority issued guidance to broker-dealers last month on their obligations to investors in private placement transactions, noting that recent examinations have found "a significant lack of regulatory compliance" in the private placement market.

"An increase in investor complaints regarding private placements, as well as SEC actions halting sales of certain private placement offerings, led FINRA to launch a nationwide initiative that involves active examinations and investigations of broker-dealers engaged in retail sales of private placement interests," FINRA CEO Rick Ketchum said in a statement. "That initiative has uncovered misconduct, including fraud and sales practice abuses. While several enforcement actions have been taken and additional investigations are underway, FINRA is taking this opportunity to remind firms of their substantial duties when engaging in the sale of private placement offerings."

FINRA Regulatory Notice 10-22 said broker-dealers are required to conduct reasonable investigations of companies issuing private placements and of their securities before recommending private placements made under Regulation D of the Securities Act.

In its focus on private placements, FINRA noted their importance as a means of capital-raising for small companies. The Securities and Exchange Commission estimated in 2008 that companies intended to issue about $609 billion of securities under Regulation D, according to FINRA.

FINRA said it's recently sanctioned firms for distributing private placement memoranda and sales materials that included inaccurate statements or that omitted necessary information to make informed investment decisions.

Regulators' renewed focus on due diligence could add to the time it takes to close some PIPE deals.

"It will slow the pace for intraday deals," said Adam Lyons, a managing director with placement agent Canaccord Adams in San Francisco. "It will lengthen the process."

While Regulation D generally requires that private placements are marketed to accredited investors and only to a limited number of non-accredited investors, FINRA emphasized that broker-dealers are still required to conduct reasonable investigations when they recommend private placements.

Broker-dealers also must have reasonable grounds to believe that an investment they are marketing is suitable for the particular customer to whom it's offered and to ensure that the customer fully understands the risks involved, FINRA said.

FINRA also noted that while private placements are exempt from registration requirements, they are governed by the antifraud provisions of federal securities laws.

FINRA said it had brought three enforcement actions in the recent months involving private placement offering violations. They include a complaint charging McGinn Smith & Co. of Albany, N.Y. and its president with securities fraud in the sales of tens of millions of dollars in the unregistered securities; the expulsion of Dallas-based Provident Asset Management from the securities business for marketing a series of fraudulent private placements offered by an affiliate in a Ponzi scheme; and fines totaling &750,000 against Pacific Cornerstone Capital of Irvine, California, and its former CEO for failing to include complete information in private placement offering documents and marketing material, as well as for advertising violations and supervisory failures.

In the wake of FINRA's notice, broker-dealers especially need to make sure they have adequate documentation of all internal meetings where decisions are made on whether to recommend a private placement offering, said William Hicks, an attorney with the law firm of Edwards Angell Palmer & Dodge in Boston. They also must make sure they have a policy for supervision of all such decisions.

"You would certainly hope a registered investment bank has rules that mandate how a lot of this gets done before its gets investment committee approval, "said Jack Hogoboom, an attorney with Lowenstein Sandler in Roseland, N.J.

The guidelines "seem to restate what we've always had to do," said David Feldman, an attorney with Feldman LLP in New York. "Broker-dealers have a responsibility to know their customers.

"I think it's great, especially when the markets are frothy," Feldman said. "There's always intense pressure to complete things before we're comfortable."  

Response to SEC's Legal Defeat

The FINRA guidelines may in part be a response to a recent court ruling that went against securities regulators, according to Mark Lab, and attorney with Lowenstein Sandler.

In the case of SEC v James Tambone and Robert Hussey, a federal appellate court rejected an attempt by regulators to hold a broker-dealer accountable for using documents that contained untrue statements of material fact.

Tambone and Hussey were executives at Colombia Funds Distributor. The SEC filed a lawsuit against them in 2005 over their marketing of mutual funds that failed to disclose that the funds allowed short-term, market-timing trades by some investors. The commission accused Tambone and Hussey of violating Section 10b-5 of the Securities Exchange Act, which bans "employment of manipulative and deceptive devices" in the sale of securities.

But Tambone and Hussey countered that the materials they used that included untrue statements had been prepared by the securities issuer - the fund management company Colombia Management Advisors - and not by themselves. They argued that Colombia Management was responsible for the materials' accuracy.

The U.S. District Court in Boston threw out the SEC's claims under Section 10b-5 in 2006. That decision was upheld last month by the U.S. Court of Appeals for the 1st Circuit.

Now, FINRA may be looking for another way to force broker-dealers to be more careful in how they rely on statements made by third parties, Lab said.

For their part, placement agents said they welcomed the guidance from FINRA on due diligence, though some said the pace of PIPEs could slow as a result.

"It's always good to do more due diligence," said Aaron Gurewitz, managing director of equity capital markets at Roth Capital Partners in Newport Beach, California. "It raises the bar on placement agents and will only add to the stability of the PIPE market."

Gurewitz said Roth Capital has done mostly registered deals and confidentially marketed public offerings, which carry underwriter liability and require significant due diligence.

"If you do an RD, you are an underwriter and you have to do your due diligence," he said.

The new guidance from FINRA may require more of placement agents who arrange unregistered deals, however.

"Part of what this does is it raises the bar on diligence for PIPEs," Gurewitz said.

A Deal in Three Hours

Rodman & Renshaw, the most active placement agent in the PIPE market, doesn't except much impact from the guidelines at all, said John Borer, Rodman's head of investment banking.

"It didn't seem to be a change," said Borer. FINRA basically said "here are some guidelines and some best practices. It's not going to change the standard operating procedure for the big placement agents."

Rodman and most other placement agents have adequate measures in place to make sure they follow the rules and best practices suggested by regulators, Borer said.

"It shouldn't slow the process down too much," Borer said. "By and large, most issuers have already been to the market and are well known. We can do a deal in three hours if we already know the company. It's rare we get a call from an issuer that isn't known."

FINRA's new focus may have more of an impact for smaller placement agents, however.

"We have all those things in place and we're held to a higher standard," said Susanne Mulligan, co-head of private placements and PIPEs at Deutsche Bank Securities in New York. "As such, the guidelines don't affect us much.

"If it brings more discipline and fiduciary duty to smaller placement agents then it makes the industry more stable," Mulligan said. "If you're not doing the due diligence and you're just facilitating the transaction, then you have no idea what's going on."