FINRA Series 22 Direct Participation Programs Representative Exam Key Study Note

FINRA Rule 2210(c)(1) generally requires pre-approval for retail communications concerning direct participation programs (DPPs) if the communication makes any financial comparison with other investment vehicles, unless the communication is limited to generic information about DPPs. The rule aims to prevent misleading comparisons. Submission for pre-approval is also required if the member firm has not previously filed retail communications with FINRA’s Advertising Regulation Department. The specific elements triggering this requirement include any direct or indirect comparison of returns, yields, safety, or liquidity between the DPP and other investments, or any projection of DPP performance that is not clearly labeled as such and based on reasonable assumptions. Failure to obtain pre-approval when required can result in disciplinary action by FINRA.

A dealer or manager participating in a DPP offering has a responsibility to conduct thorough due diligence to ensure the offering is suitable for investors. FINRA Rule 2310(b)(3) mandates a review of material statements and risk factors in the offering documents, compliance with registration or exemption rules, financial data and assets, management background and prior performance, assumptions in offering forecasts or projections, fees and use of proceeds, and the opinion of tax counsel. This due diligence is crucial to ensure compliance with Section 11 of the Securities Act of 1933, which imposes civil liabilities for false registration statements. Failure to conduct adequate due diligence can expose the dealer or manager to legal and regulatory repercussions, including liability for investor losses.

Regulation D provides exemptions from the registration requirements of the Securities Act of 1933 for certain private placements. Rule 504 allows for offerings up to $5,000,000 within a 12-month period, and while it doesn’t mandate specific disclosure requirements, it does require compliance with state securities laws. Rule 506, on the other hand, has no limit on the offering amount but restricts sales to accredited investors and up to 35 non-accredited investors who are sophisticated. Rule 506 requires providing specific disclosures to non-accredited investors, as outlined in Rule 502(b), similar to those found in a registered offering. The choice between Rule 504 and Rule 506 depends on the capital needs and investor base of the DPP. Failure to comply with the specific requirements of either rule can result in the loss of the exemption and potential legal liabilities under Section 5 of the Securities Act of 1933.

The Employee Retirement Income Security Act of 1974 (ERISA) governs retirement plans, including those investing in DPPs. ERISA’s “prudent man” rule requires plan fiduciaries to act with the care, skill, prudence, and diligence that a prudent person would use under similar circumstances. This means fiduciaries must conduct thorough due diligence on any DPP investment, considering its risks and potential returns in the context of the plan’s overall investment strategy. Furthermore, DPPs can generate unrelated business taxable income (UBTI) for retirement plans if the DPP engages in a trade or business that is unrelated to the plan’s exempt purpose. UBTI is taxable to the plan, potentially reducing returns. Fiduciaries must be aware of these implications and take steps to mitigate risks and ensure compliance with ERISA.

FINRA Rule 2090, the “Know Your Customer” (KYC) rule, requires Series 22 representatives to use reasonable diligence to know and retain the essential facts concerning every customer and their investment objectives. This rule is foundational for complying with FINRA Rule 2111, which mandates that recommendations be suitable for the customer. Essential facts include the customer’s financial situation (income, net worth, assets, liabilities), tax status, investment experience, investment objectives (preservation of capital, income, growth, speculation), and risk tolerance. For example, a representative must understand if the customer has sufficient net worth and liquidity to withstand the potential loss of investment in a speculative DPP, and whether the DPP aligns with their stated investment goals. Failure to gather and analyze these facts can lead to unsuitable recommendations and potential regulatory violations.

When recommending an oil and gas exploratory program, a Series 22 representative must conduct a thorough suitability analysis and disclose all relevant risks and potential benefits. Exploratory programs carry high risk due to the uncertainty of finding commercially viable reserves (“dry holes”). Potential benefits include up-front tax benefits and high return potential from reserve discoveries. Risks include joint and several liability, environmental hazards, changing government regulations, and commodity price volatility. The representative must ensure the client understands these risks and has the financial capacity to absorb potential losses. Disclosure must also include the sponsor’s track record, the program’s economic soundness, and any conflicts of interest. This is in line with FINRA Rule 2310(b), which emphasizes the importance of providing full and fair disclosure to investors in DPPs.

FINRA Rule 2210(c)(6) stipulates pre-filing requirements for retail communications concerning DPPs. Specifically, if a member firm has not previously filed advertisements concerning DPPs with FINRA’s Advertising Regulation Department, it must file such communications at least 10 business days prior to first use for a period of one year. After this initial period, filings are no longer required unless FINRA determines that the member has made misleading or inaccurate statements. Furthermore, all retail communications must prominently disclose the salient risks of investing in DPPs, including but not limited to illiquidity, potential tax consequences, and the speculative nature of certain DPP investments. The communication must also provide a balanced presentation, avoiding exaggerated claims or misleading statements about potential benefits.

A dealer or manager in a DPP syndication has a stringent due diligence obligation. FINRA Rule 2310(b)(3) mandates a thorough review of the DPP, encompassing material statements and risk factors in offering documents, compliance with registration or exemption rules, financial data and assets, management background and prior performance, assumptions in offering forecasts or projections, fees and use of proceeds, and the opinion of tax counsel. This due diligence is crucial to ensure the offering is suitable for investors. Furthermore, Sections 11 and 12 of the Securities Act of 1933 impose civil liabilities for false or misleading statements in a registration statement or prospectus, reinforcing the importance of accurate and comprehensive due diligence. Failure to conduct adequate due diligence can expose the dealer or manager to legal and regulatory repercussions.

Regulation D provides exemptions from the registration requirements of the Securities Act of 1933 for certain private placement offerings. Rule 504 allows for offerings up to $5,000,000 within a 12-month period, with no limitation on the number of investors, although state registration requirements may apply. Rule 506, on the other hand, has no limit on the offering size but restricts sales to accredited investors and up to 35 non-accredited investors who must be sophisticated (i.e., possess sufficient knowledge and experience in financial matters). While Rule 504 may require specific state filings, Rule 506 preempts state registration requirements, offering greater flexibility for national offerings. Both rules require the filing of a Form D with the SEC, as per Rule 503.

ERISA imposes stringent requirements on fiduciaries of retirement plans, including the “prudent man” rule, which mandates that investments be made with the care, skill, prudence, and diligence that a prudent person would use under similar circumstances. Investing in DPPs, which are often illiquid and complex, can pose challenges to meeting this standard. Furthermore, ERISA prohibits certain transactions between a plan and “parties in interest,” which can include the DPP sponsor or its affiliates. If a retirement plan invests in a DPP where such a prohibited transaction occurs, the fiduciary could be held liable for breaching their fiduciary duty. Therefore, careful consideration of ERISA’s requirements is essential before recommending DPP investments to retirement plans.

The “Know Your Customer” (KYC) rule, as outlined in FINRA Rule 2090, requires broker-dealers to make reasonable efforts to obtain and maintain information about their customers, including their financial situation, investment experience, and investment objectives. This information is crucial for assessing the suitability of DPP investments. FINRA Rule 2111, the suitability rule, prohibits recommending a transaction or investment strategy unless the broker-dealer has a reasonable basis to believe that the recommendation is suitable for the customer. SEC Rule 15l-1, Regulation Best Interest, further strengthens this obligation by requiring broker-dealers to act in the best interest of their retail customers when making recommendations. Therefore, KYC is the foundation upon which suitability and best interest obligations are built, ensuring that DPP recommendations are aligned with the customer’s individual circumstances and needs.

DPPs are rife with potential conflicts of interest. The general partner, who manages the partnership, has a fiduciary duty to act in the best interests of the limited partners. However, conflicts can arise when the general partner has other business interests that may compete with the DPP, or when the general partner receives compensation that is not directly tied to the performance of the DPP. These conflicts are typically addressed in the partnership agreement, which should clearly define the general partner’s responsibilities, limitations on their activities, and the methods for resolving conflicts. Disclosure of these conflicts is also crucial to ensure that limited partners are aware of the potential risks. Failure to adequately address and disclose conflicts of interest can lead to legal and regulatory action.

DPPs are often marketed for their tax benefits, but understanding the tax implications is crucial. DPPs are typically pass-through entities, meaning that income and losses are passed directly to the investors. Passive income and losses are generated from business activities in which the investor does not materially participate. Passive losses can only be used to offset passive income, limiting their immediate tax benefit. The “at-risk” rules limit the amount of losses an investor can deduct to the amount they have at risk in the investment. Furthermore, certain DPP preference items can trigger the Alternative Minimum Tax (AMT), potentially increasing an investor’s tax liability. These factors significantly influence the suitability of DPPs for different investors, as those with limited passive income or a high risk of triggering AMT may not benefit from the investment.

Broker-dealers participating in DPP offerings have a stringent due diligence obligation to ensure the offering is suitable for investors and that all material information is accurately disclosed. This responsibility is underscored by FINRA Rule 2310(b)(3), which mandates that members have reasonable grounds to believe that all material facts are adequately disclosed and provide a basis for evaluating the DPP. Due diligence typically involves a comprehensive review of several key areas, including: **Material Statements and Risk Factors:** Examining the accuracy and completeness of statements made in the offering documents, particularly regarding risk factors. **Compliance with Registration or Exemption Rules:** Verifying that the DPP complies with all applicable registration requirements under the Securities Act of 1933 or qualifies for a valid exemption, such as Regulation D. **Financial Data and Assets:** Analyzing the financial condition of the program, including its assets, liabilities, and cash flow projections. **Management Background and Prior Performance:** Investigating the background and experience of the program’s management team, as well as their past performance in similar ventures. **Assumptions in Offering Forecasts or Projections:** Evaluating the reasonableness of assumptions underlying any financial forecasts or projections included in the offering documents. **Fees and Use of Proceeds:** Scrutinizing the fees charged by the program sponsor and ensuring that the use of proceeds is clearly disclosed and aligned with the program’s objectives. **Opinion of Tax Counsel:** Reviewing the opinion of tax counsel regarding the tax consequences of investing in the DPP. Failure to conduct adequate due diligence can expose a broker-dealer to significant liabilities. Under Section 11 and 12 of the Securities Act of 1933, broker-dealers can be held liable for material misstatements or omissions in the registration statement or prospectus. Furthermore, FINRA may impose disciplinary actions for violations of Rule 2310, including fines, suspensions, or even expulsion from the industry. Investors may also pursue legal claims against broker-dealers for negligence, breach of fiduciary duty, or violations of securities laws. The extent of liability is often determined by the degree of negligence and the materiality of the misstatements or omissions.