After a year that saw blowups of sizable Reg D offerings sold by independent broker-dealers, the private-placement industry is creating an industry guide for best practices when firms sell the high-risk products.
A draft of the proposed guide was rolled out at a panel in Las Vegas Sunday during the annual meeting of the Real Estate Investment Securities Association. Stephen Burr, a partner with Foley & Lardner LLP, worked on the draft and was the chairman of the REISA panel.
The best-practices guide focuses on three areas: private notes, oil and gas deals, and real estate funds.
“The [private placement] sponsors and the broker-dealers decided it would be better for them from the perspective that everybody in the industry is trying to measure up to a certain level of quality, to have guidelines,” Mr. Burr said after the panel.
In July 2009, the Securities and Exchange Commission charged two private placement issuers, Provident Royalties LLC and Medical Capital Holdings Inc., with fraud. Combined, the two raised close to $2.7 billion, and each sold their products through networks of independent broker-dealers. Many of those B-Ds are now facing arbitration claims from investors and scrutiny from securities regulators about how the products were sold.
Such private placements are marketed almost exclusively through independent broker-dealers, which at times don't perform their own due diligence on the Reg D deals. Since Provident and Medical Capital have shut down, a number of executives with independent broker-dealers have said they rely on outside reports on the offerings. Those reports are often paid for by the product sponsor, because it is too expensive for B-Ds to perform due diligence on the dozens of private placements that sponsors pitch to them each year.
When questioned about that practice, due-diligence analysts who write the reports routinely say they are independent of the sponsor, and, in fact, at times write negative reports.
That said, even a report from a sponsor-paid analyst doesn't let a broker-dealer off the hook for due diligence, said Mr. Burr and other analysts and lawyers at the meeting. “Before, in the industry, there may have been some sense that if the sponsor did due diligence, and gave them the results of that, and if the broker-dealer got a third party due-diligence report, that was enough,” he said. “Not every broker-dealer thought that way, but some fell in to that, especially when things were busy.”
The practice of the sponsor paying for due diligence has drawn the attention of securities regulators. In April, the
Financial Industry Regulatory Authority Inc. issued guidance in a notice to members saying that firms can't rely solely on the private placement sponsor for third-party due diligence, said Mr. Burr.
Finra emphasized that firms need to perform their own due diligence when selling private placements. “When presented with red flags, the broker-dealer must do more than simply rely upon representations by [an] issuer's management, the disclosure in an offering document, or even a due diligence report of [an] issuer's counsel,” the Finra notice states.
The REISA due-diligence best-practices guide reflects those concerns. “Broker-dealers may not rely solely upon the accuracy of information supplied by the sponsor or its agents, but must engage in an independent due-diligence investigation that is customized for each offering. Most offerings may have certain unique features that require additional due diligence,” according to the draft of the due-diligence best-practices guide, which will now be considered by REISA's board.
