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Compliance Concepts

Reasonable Diligence for Private Placements (FINRA Exam Findings – Part 4)

December 15, 2018

by Howard Haykin


Firms have an obligation to conduct a reasonable investigation” with regard to private placements – including steps to evaluate ... "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.” Failure to do so could result in violations of FINRA Rule 2111 (Suitability) and FINRA Rule 3110 (Supervision).  [See FINRA RegNote 10-22.]




Reasonable diligence by member firms with regard to private placements is typically characterized by:

  • meaningful, independent research of material aspects of the offering;
  • identification of red flags with the offering or the issuer;
  • addressing and resolving of concerns that would be relevant to a potential investor;
  • creation of a due diligence committee (at larger firms) or formal designation of one or more qualified persons (at smaller firms), and charging them with investigating and determining whether to approve the offering for sale to investors.


When offerings involve issuers that were affiliates of the firm or whose control persons were also employed by the firm, reasonable diligence would be extended to address:

  • mitigating conflicts of interest;
  • ensuring that the offerings were suitable for investors in spite of such conflicts of interest;
  • developing comprehensive disclosures;
  • establishing post-approval processes and investment limits based on the complexity or risk level of the offering.


Additional pointers would include:

  • After the offering, ongoing diligence to ascertain whether offering proceeds were used in a manner consistent with the offering memorandum, particularly when the firms engaged in ongoing sales of an offering after initial closing;
  • documentation of both the “process and results” of a firm's diligence analysis.




Insufficient diligence efforts (in scope or depth) by member firms with regard to private placements might include:


  • No Reasonable Diligence – Prior to recommending offerings to retail investors, some firms:
    • performed no additional research about new offerings because they relied on their experience with the same issuer in previous offerings.
    • reviewed the offering memorandum and other relevant offering documentation, but did not discuss the offering in greater detail with the issuer or independently verify, research or analyze material aspects of the offerings.
    • did not investigate red flags identified during the reasonable diligence process – e.g., in offerings involving conservation tax easements, some firms did not investigate red flags that included, but were not limited to, significant risk of the IRS disallowing tax deductions, as well as concerns regarding land appraisals.


  • Overreliance on Third Parties – Upon receiving due diligence reports prepared by due diligence consultants, experts or other 3rd-party vendors, some firm did not independently evaluate the provided conclusions, respond to red flags or significant concerns noted in the reports; nor did address concerns about the issuer or the offering that were apparent outside the context of the report.


  • Potentially Conflicted Third-Party Due Diligence – Some firms did not consider possible conflicts of interest when evaluating and assessing 3rd-party reports that issuers had paid for or provided in their due diligence analysis.



This being the 4th post of a series covering the release of FINRA’s findings from 2018 examinations, we invite you to read our other Financialish posts in this series: