Capitol Hill

In addition to our monthly case study, we're featuring highlights of the recently passed Dodd-Frank Act which may warrant expanding certain types of investigations. One of the Act's provisions (Section 926)requires that the Securities & Exchange Commission (SEC) "adopt rules disqualifying persons who are subject to certain final orders by state securities regulators or state or federal banking regulators, or who have been convicted of a felony or misdemeanor relating to securities or false filings with the SEC, from participating in exempt offerings of securities under Regulation D." Thus, under the Act, enforcement actions by state and federal authorities will limit violators' ability to raise capital through private placements.

Investment news publications reported in August 2010 that Section 914 of the Act requires the SEC to "harmonize" with the Financial Industry Regulatory Authority (FINRA) the different standards of care that apply to broker-dealers and to other investment advisers, if necessary. But FINRA already has related rules; this provision compels their expansion. In April 2010, before the Act was signed into law, FINRA issued Regulatory Notice 10-22 reminding broker-dealers of their obligation - enforceable under federal securities laws and FINRA rules - to conduct a "reasonable" investigation of the issuer and the securities they recommend in offerings made pursuant to Regulation D under the Securities Act of 1933.

The Notice also reinforces the obligations of broker-dealers that recommend securities offered under Regulation D to comply with the suitability requirements of NASD Rule 2310, the advertising and supervisory rules of FINRA and the rules and regulations of the SEC. Among FINRA's Notice guidelines in a Regulation D offering, a broker-dealer should, at a minimum, conduct a "reasonable" investigation of the issuer and its management, business prospects of the issuer, assets held by or to be acquired by the issuer, representations and claims being made, and intended use of proceeds of the offering. While there are no set parameters on the scope of the investigation, factors such as the nature of the recommendation, the role of the broker in the transaction, its knowledge of and relationship to the issuer, the size and stability of the issuer, experience and reputation of the principals, and any "red flags" should be taken into consideration. The SEC and courts recognize that a more thorough investigation is required for securities issued by smaller companies of recent origin, and where promotional materials may be questionable, i.e., making promises of unusually high returns. A broker-dealer must conduct a "reasonable" investigation in connection with each offering, notwithstanding that a subsequent offering may be for the same issuer.

FINRA also notes that the duty of the inquiry under the anti fraud provisions of federal securities laws is distinguished from the "reasonable" investigation in that, under Section 11(b) of the Securities Act, it permits an underwriter to avoid liability for misrepresentations in a registration statement. FINRA further states that courts have compared the Section 11 "reasonable" investigation requirements with the broker-dealer's general duty to investigate, and concluded that "more" is required of an underwriter than a broker-dealer in order to discharge its obligation to the investing public.