The core of this scenario revolves around the registered representative’s reasonable basis due diligence obligations under FINRA Rule 2310. This rule requires the member firm and its representatives to have a reasonable basis to believe that a direct participation program is suitable for at least some investors. This involves a thorough investigation into the fundamental economic viability of the program itself, independent of any single investor’s profile. For an equipment leasing program, particularly one involving high-value, long-life assets like aircraft, the single most critical assumption driving the investment’s potential return is the residual value of the equipment at the end of the lease terms. An overly optimistic projection of residual value can mask a fundamentally unsound program, leading to significant losses for investors when the assets are eventually sold for far less than anticipated. In this case, the representative’s most significant failure was accepting the sponsor’s highly aggressive and unsubstantiated residual value projections without independent verification. A projection that aircraft will only depreciate by a minimal amount over a decade is a major red flag that demands scrutiny. Proper due diligence would involve seeking independent, third-party appraisals, analyzing historical market data for similar assets, and stress-testing the projections against various scenarios, such as technological advancements rendering the aircraft obsolete or shifts in airline demand. Simply relying on the sponsor’s claims in the Private Placement Memorandum, without challenging the core economic assumptions, is a direct violation of the duty to investigate the economic soundness of the program as mandated by FINRA Rule 2310. The other issues noted are valid concerns but are secondary to the failure to validate the primary assumption upon which the entire financial success of the program rests.

The core issue is the dealer-manager’s decision to proceed with an offering despite having knowledge of a potential material misstatement in the Private Placement Memorandum (PPM). The most significant liability stems from Section 12(a)(2) of the Securities Act of 1933. This section imposes civil liability on any person who offers or sells a security by means of a prospectus or oral communication which includes an untrue statement of a material fact or omits to state a material fact. In this context, the PPM serves as the primary disclosure document, and courts have extended the applicability of Section 12(a)(2) to such documents in solicited private placements. The dealer-manager, by distributing the PPM and soliciting investors, is considered a statutory “seller.” The primary defense against a Section 12(a)(2) claim is that the seller did not know, and in the exercise of reasonable care could not have known, of the untruth or omission. Here, the dealer-manager’s own due diligence uncovered the questionable nature of the projection, and they chose to ignore it. This negates the “reasonable care” defense, creating direct liability to purchasers who can sue for rescission of their investment or for damages. While a violation of FINRA Rule 2310 (requiring due diligence) has also occurred, the resulting SRO disciplinary action is separate from, and often less financially severe than, the direct civil liability owed to investors under federal securities law. Section 11 liability is inapplicable as it pertains specifically to misstatements in a registration statement for a public offering, not a private placement.

The calculation for the investor’s maximum deductible loss is based on their at-risk basis in the partnership. The at-risk basis is the amount of money the investor personally stands to lose. Initial At-Risk Basis Calculation: 1. Start with the cash contribution: \(\$80,000\) 2. Add the investor’s share of recourse debt (for which they are personally liable): \(\$15,000\) 3. Add the investor’s share of qualified non-recourse financing. This is a special rule for real estate activities where certain non-recourse debt (typically from a commercial lender) is treated as being at-risk: \(\$40,000\) 4. Do not add the non-qualified non-recourse financing (e.g., seller financing or loans from a related party), as this does not increase the at-risk amount. Total At-Risk Basis = Cash Contribution + Recourse Debt + Qualified Non-Recourse Financing \[\$80,000 + \$15,000 + \$40,000 = \$135,000\] The investor’s share of the partnership’s passive loss for the year is \(\$150,000\). However, an investor can only deduct passive losses up to their at-risk basis. Therefore, the maximum deductible loss for the year is \(\$135,000\). The remaining \(\$15,000\) loss (\(\$150,000 – \$135,000\)) is suspended and may be carried forward to future years, to be deducted when the at-risk basis increases. The at-risk rules, as defined by the Internal Revenue Service, limit a taxpayer’s deductible losses from an investment to the amount the taxpayer has at risk in the activity. This amount generally includes the cash contributed to the activity, the adjusted basis of property contributed, and amounts borrowed for use in the activity for which the taxpayer is personally liable. A crucial exception exists for real estate activities. Under this exception, qualified non-recourse financing is treated as an amount at risk. Qualified non-recourse financing is typically debt secured by real property and borrowed from a qualified person, such as a bank or commercial lending institution, who is not related to the borrower. This rule allows real estate investors to include this specific type of debt in their at-risk basis, thereby increasing their potential for loss deductions. However, other forms of non-recourse debt, such as seller financing or loans from a partner, are generally not considered qualified and do not increase the at-risk basis. The annual loss deduction is capped at this at-risk amount, and any excess loss is carried forward indefinitely until the investor has sufficient at-risk basis to absorb it.

The core of this issue lies in the fundamental structural and tax-related differences between various pass-through business entities. When choosing an entity, sponsors and investors must consider how profits, losses, and distributions will be allocated. Certain structures offer significant flexibility, while others impose strict limitations. Partnerships, including limited partnerships (LPs), general partnerships (GPs), and limited liability companies (LLCs) taxed as partnerships, are defined by their partnership or operating agreements. These agreements are highly customizable and allow for what are known as special or disproportionate allocations. This means that profits and losses can be distributed among partners in a ratio that is different from their respective capital contributions. This flexibility is a key advantage, as it allows the entity to reward partners for contributions of services, expertise, or assumption of risk, not just capital. In contrast, an S Corporation, despite being a pass-through entity, has a much more rigid structure. A primary requirement for maintaining S Corp status is that the corporation may only have one class of stock. The IRS interprets this to mean that all distributions to shareholders, including profits and losses, must be made strictly on a pro-rata basis according to the percentage of shares each shareholder owns. A shareholder who owns 25% of the stock must receive 25% of any distribution. Attempting to create a disproportionate allocation scheme, such as the one described in the scenario, would effectively create a second class of stock, thereby violating the S Corp requirements and potentially leading to the termination of the entity’s S Corp status by the IRS.

Step 1: Identify the client’s stated critical financial constraint. The client, Anika, is specifically sensitive to the Alternative Minimum Tax (AMT). Step 2: Identify the primary advertised benefit of the investment. The oil and gas developmental program offers significant upfront tax deductions derived from Intangible Drilling Costs (IDCs). Step 3: Analyze the relationship between the program’s benefit and the client’s constraint. Under the U.S. Tax Code, excess IDCs are a significant tax preference item. Tax preference items are deductions allowed for regular tax purposes but are added back to a taxpayer’s income when calculating their potential liability under the AMT system. Step 4: Synthesize the findings to determine the most critical due diligence point. The very feature that makes the program attractive from a regular tax perspective (large IDC deductions) is the same feature that creates a significant risk for this specific client (triggering AMT). This direct conflict between the program’s structure and the investor’s specific tax profile makes it the most crucial issue to address. While other factors like conflicts of interest or sharing arrangements are valid risks related to the program’s general economic viability, the AMT issue directly undermines the suitability of the investment for this particular investor’s stated needs. A registered representative’s due diligence obligation under FINRA Rule 2310 requires a thorough investigation of a Direct Participation Program’s features, risks, and economic soundness. This responsibility extends beyond a general review and must incorporate the specific financial profile and investment objectives of the client, as mandated by suitability and best interest regulations. In the context of oil and gas programs, a primary benefit is often the ability to deduct a large portion of the initial investment as Intangible Drilling Costs. However, these IDCs are also a well-known tax preference item for the Alternative Minimum Tax. The AMT is a separate, parallel tax calculation that ensures high-income individuals pay at least a minimum amount of tax by disallowing certain deductions and credits. For an investor who is already close to or subject to the AMT, an investment that generates substantial tax preference items can be unsuitable. The tax benefits advertised under the regular tax system could be partially or completely eliminated by the AMT, potentially resulting in a higher overall tax liability for the investor. Therefore, when a client explicitly states a sensitivity to AMT, the most critical diligence point for the representative is to analyze and disclose how the program’s tax features, such as IDCs, will impact the client’s AMT status. This specific suitability analysis takes precedence over more general program risks.

No calculation is required for this conceptual question. The core responsibility of a broker-dealer under FINRA Rule 2210, Communications with the Public, is to ensure that all communications are based on principles of fair dealing and good faith, are fair and balanced, and are not misleading. This includes a prohibition on making false, exaggerated, unwarranted, promissory, or misleading statements or claims. The marketing material described in the scenario directly violates these principles by featuring unverified, highly optimistic projections and omitting a balanced presentation of the substantial risks inherent in an exploratory oil and gas program. Specifically, risks such as dry holes, commodity price volatility, and geopolitical factors are material information that must be presented with equal prominence to any discussion of potential returns. Furthermore, this communication failure is directly linked to the broker-dealer’s due diligence obligations under FINRA Rule 2310. A member firm must perform a reasonable investigation of the direct participation program and cannot simply rely on the sponsor’s claims. The use of the sponsor’s unverified projections without independent analysis and a balanced risk disclosure demonstrates a failure in this due diligence process. While Rule 506(c) of Regulation D permits general solicitation, it does not grant an exemption from the content standards of Rule 2210. The communication must be fair and balanced regardless of the method of solicitation or the ultimate accreditation status of the investor. The misleading nature of the content is the most significant and foundational violation.

The calculation to determine compliance with FINRA Rule 2310 involves two key thresholds: total underwriting compensation and total organization and offering (O&O) expenses. First, calculate the total underwriting compensation. This includes sales commissions, dealer-manager fees, and wholesaling fees. Bona fide, itemized due diligence expenses are excluded from this specific calculation. Total Underwriting Compensation = Sales Commission + Dealer-Manager Fee + Wholesaling Fee Total Underwriting Compensation = \(8\% + 2\% + 1.5\% = 11.5\%\) Next, compare this to the FINRA limit. FINRA Rule 2310(b)(4) limits total underwriting compensation to a maximum of 10% of the gross offering proceeds for a public DPP. The calculated compensation of 11.5% exceeds the 10% limit. Therefore, the structure is non-compliant. Separately, one can calculate the total O&O expenses. This includes all underwriting compensation plus other organizational costs, such as bona fide due diligence expenses. Total O&O Expenses = Total Underwriting Compensation + Due Diligence Expenses Total O&O Expenses = \(11.5\% + 0.75\% = 12.25\%\) FINRA Rule 2310(b)(4) limits total O&O expenses to 15% of gross proceeds. While the 12.25% is below the 15% overall cap, the offering is still non-compliant because the 10% sub-limit for underwriting compensation has been violated. Under FINRA Rule 2310, which governs Direct Participation Programs, there are strict limits on the compensation and expenses associated with a public offering. The rule establishes a two-tiered cap. The first cap limits total underwriting compensation to 10% of the gross proceeds of the offering. This category includes all compensation paid to broker-dealers involved in the distribution, such as sales commissions paid to the selling group, dealer-manager fees, and wholesaling fees paid to third parties for their assistance in marketing the program. The second, broader cap limits total organization and offering expenses to 15% of the gross proceeds. This 15% O&O cap includes all the items from the 10% underwriting cap, plus other expenses necessary to structure the offering, such as legal fees, accounting fees, and printing costs. A key distinction is that bona fide, itemized due diligence expenses reimbursed to a broker-dealer are not considered underwriting compensation for the purposes of the 10% limit, but they are included as part of the overall 15% O&O expense limit. An offering must comply with both of these limits. A violation of the 10% underwriting compensation sub-limit renders the entire compensation structure non-compliant, even if the total O&O expenses fall below the 15% threshold.

The principal’s primary duty is to ensure the video communication is fair, balanced, and not misleading under FINRA Rule 2210. This involves verifying that the video’s claims about high-return potential are adequately balanced with prominent disclosures about the substantial risks inherent in an exploratory oil and gas program. Under FINRA Rule 2210, any communication distributed or made available to more than 25 retail investors within any 30 calendar-day period is defined as retail communication. A video posted on a public website and social media channels clearly falls into this category. All retail communications must be approved by an appropriately qualified registered principal before the earlier of its use or filing with FINRA’s Advertising Regulation Department. The core of this approval process is a substantive review of the content to ensure it is fair, balanced, and not misleading. For a high-risk investment like an exploratory oil and gas DPP, which has a significant chance of failure (e.g., “dry holes”) and is subject to commodity price volatility, it is a serious violation to promote high potential returns without giving equal or greater prominence to the associated risks. While the offering is conducted under SEC Regulation D, Rule 506(c), which permits general solicitation and advertising, this does not negate the firm’s obligation to comply with FINRA’s content standards for public communications. The permission to advertise is conditioned on the advertising itself being compliant. The verification of an investor’s accredited status is a separate, critical step that must be taken before a sale can be completed, but the principal’s initial and primary focus for the advertisement itself is the content and its adherence to the fair balance standard.

The primary regulatory issue stems from the prohibition against general solicitation and advertising for offerings conducted under Rule 506(b) of Regulation D. Regulation D provides an exemption from the registration requirements of the Securities Act of 1933, but issuers must strictly adhere to its conditions. Rule 506(b) allows sales to an unlimited number of accredited investors and up to 35 non-accredited (but sophisticated) investors. A critical condition of this rule is that the issuer and its representatives cannot engage in any form of general solicitation or advertising to market the securities. General solicitation includes communications broadcast to the public, such as advertisements in newspapers, on television, or over the internet, as well as seminars whose attendees have been invited by general solicitation. Sending a promotional email to individuals with whom the representative or the firm does not have a pre-existing, substantive relationship is considered general solicitation. A pre-existing relationship implies the connection was formed before the offering began, and a substantive relationship means the firm has sufficient information to evaluate the person’s financial circumstances and sophistication. In this scenario, sending the email to prospects met at a conference, whose financial status is unknown, violates this condition. This action jeopardizes the entire offering’s exempt status, which is a far more severe consequence than a content violation within a permissible communication. While rules on balanced presentation are important, they apply to communications that are permissible in the first place. Invalidating the legal basis for the offering is the most critical failure.

This scenario describes a violation of rules governing contingency offerings. When an offering is presented on an “all-or-none” or “part-or-none” (mini-max) basis, it is represented to investors that their funds will be returned if a specific minimum amount of capital is not raised from the public by a certain date. This contingency provides a key protection, assuring investors that the project will only proceed if it achieves the minimum funding level deemed necessary for economic viability, subscribed by bona fide, at-risk purchasers. SEC Rule 10b-9 specifically makes it a manipulative and deceptive practice to represent an offering as having a contingency unless that contingency is strictly adhered to. Arranging for a non-bona fide purchase, such as from an affiliated entity with a repurchase agreement, to merely satisfy the minimum threshold creates a false impression that the contingency has been met. This action directly undermines the protective purpose of the contingency. The purchase is not a genuine, at-risk investment from the public. Therefore, closing the offering and releasing funds from escrow under these circumstances is a fraudulent act. The core of the violation is not the handling of the escrow itself, but the misrepresentation that the conditions for breaking escrow have been legitimately fulfilled. This type of arranged purchase to meet a minimum is a classic example of a prohibited practice under the rule.

The most significant regulatory violation in this scenario is the circumvention of the “all-or-none” contingency, which is a manipulative and deceptive act under SEC Rule 10b-9. An all-or-none offering provision is a material term of the offering. It provides a crucial protection to investors by assuring them that if the program does not raise its minimum required capital through legitimate public sales, their funds will be returned. This ensures the venture is not undercapitalized, which would increase its risk of failure. In this case, the sponsor arranged for a non-bona fide purchase by an affiliate using funds that were not independent, at-risk capital. This transaction was designed solely to create the appearance that the minimum offering amount was met. Such a purchase does not count as a genuine sale for the purposes of satisfying the contingency. By closing the offering based on this artificial purchase and releasing the escrowed funds, the sponsor engaged in a fraudulent practice. This action deceived the legitimate investors into believing that the offering had garnered sufficient public interest to be viable, when in fact it had not. This violation is more fundamental than other potential issues like due diligence failures or risk disclosures, as it pertains to the fraudulent execution of the offering itself, rendering the entire transaction invalid from its inception under the stated terms. A broker-dealer’s due diligence obligations under FINRA Rule 2310 would include taking steps to ensure that such contingencies are met legitimately.

The calculation to determine the total Organization and Offering (O&O) expenses as a percentage of the gross offering proceeds is as follows: \[ \text{Total O\&O Percentage} = \text{Underwriting Commissions} + \text{Organizational Costs} + \text{Sponsor’s Expense Allowance} \] \[ \text{Total O\&O Percentage} = 7\% + 6\% + 3\% = 16\% \] The total calculated O&O expenses are 16% of the gross proceeds. Under FINRA Rule 2310, member firms are prohibited from participating in a public offering of a direct participation program if the total organization and offering expenses exceed 15% of the gross proceeds of the offering. While this scenario involves a private placement under Regulation D, FINRA applies these compensation guidelines to its member firms participating in such offerings to ensure fairness and reasonableness of fees. Organization and offering expenses are broadly defined to include not only direct underwriting compensation but also all other costs incurred by the issuer that are related to the offering. This includes items like legal and accounting fees, printing costs, filing fees, and various reimbursements or expense allowances paid to the sponsor or general partner. In this case, the 7% underwriting commission, the 6% for organizational costs, and the 3% non-accountable expense allowance to the sponsor must all be aggregated. The sum of these expenses is 16%, which surpasses the 15% regulatory ceiling established by FINRA. This makes the fee structure non-compliant. A representative performing due diligence has a responsibility to identify such discrepancies and recognize that the structure is impermissible for a member firm’s participation.

The core concept tested is the creation of phantom income within a leveraged direct participation program, specifically an equipment leasing partnership. Phantom income is taxable income that is not accompanied by a corresponding cash flow to the investor. In this scenario, the program utilizes accelerated depreciation, which provides large, non-cash tax deductions in the early years of the investment. This rapidly reduces the tax basis of the leased equipment. The tax basis is the original cost of the asset minus all accumulated depreciation. When the equipment is eventually sold, the taxable gain is calculated as the sale price minus the adjusted (depreciated) tax basis. Because the basis has been significantly reduced, a large taxable gain can be realized even if the equipment is sold for less than its original purchase price. Concurrently, the program may have used leverage (a loan) to purchase the equipment. The cash proceeds from the sale of the equipment are first used to satisfy any outstanding debt. It is common for the remaining loan balance to be equal to or greater than the sale proceeds, resulting in little to no cash being distributed to the limited partners. However, the large taxable gain is still passed through to the partners on their Schedule K-1. Consequently, the investor is liable for taxes on this “phantom” income without receiving the cash to pay for it, creating a significant and often unexpected financial burden in the later years of the program. A representative must ensure the client understands this specific long-term risk, as it is a fundamental characteristic of many tax-advantaged DPPs.

The offering is being conducted under Regulation D, Rule 506(c) of the Securities Act of 1933. A key condition of this rule, which permits general solicitation and advertising, is that the issuer must take “reasonable steps to verify” that all purchasers are, in fact, accredited investors. This is a higher and more active standard than that required for a Rule 506(b) offering, where an issuer can often rely on a pre-existing, substantive relationship and the investor’s self-certification. In a 506(c) offering, because the investor may be a stranger who responded to a public advertisement, the firm cannot simply accept a signed subscription agreement or a simple attestation as sufficient proof. The SEC has provided a principles-based method for this verification, where the reasonableness of the steps taken depends on the specific facts and circumstances. While there are non-exclusive safe harbor methods for verification (such as reviewing tax returns, bank statements, or obtaining a written confirmation from a registered broker-dealer, investment adviser, attorney, or CPA), relying on a letter from a foreign attorney, whose credentials and basis for the attestation are unknown, would likely not be considered a reasonable step without further investigation. The firm’s primary and most critical compliance obligation in this specific context is to satisfy this verification requirement. Failure to do so could jeopardize the entire offering’s exemption from registration for all investors, creating significant legal and regulatory liability for the issuer and the broker-dealer. This verification step is a specific gatekeeping function that precedes the general suitability determination under FINRA rules.

The core issue stems from the specific requirements of a Regulation D, Rule 506(c) offering. While this rule permits general solicitation and advertising, which the social media post represents, it imposes a heightened and non-delegable duty on the issuer and its agents to verify the status of purchasers. The standard is to take “reasonable steps to verify” that all purchasers are, in fact, accredited investors. This is a significantly higher burden than the “reasonable belief” standard applicable to Rule 506(b) offerings, where no general solicitation is permitted. The principal’s approval of the communication under FINRA Rule 2210 addresses the content of the advertisement, ensuring it is fair, balanced, and not misleading. However, this approval is entirely separate from, and does not satisfy, the procedural requirements mandated by the Securities Act of 1933 for the offering itself. The primary compliance risk is the potential failure to have and execute a robust verification process for every investor solicited through this public channel. Simply including a disclaimer in the advertisement is insufficient. The firm must actively verify status through methods such as reviewing tax returns, bank statements, or obtaining written confirmation from a qualified third party like a CPA or attorney before accepting any investment.

The first step is to determine the classification of the electronic communication based on its audience. FINRA Rule 2210 defines three types of communications: correspondence, retail communication, and institutional communication. Correspondence is defined as any written communication, including electronic, distributed to 25 or fewer retail investors within a 30-calendar-day period. Retail communication is defined as any written communication, including electronic, distributed to more than 25 retail investors within a 30-calendar-day period. In this scenario, the email is being sent to 30 existing retail clients. Since the number of recipients (30) is greater than 25, the email is classified as a retail communication. The second step is to identify the compliance obligation associated with this classification. FINRA Rule 2210 mandates that a registered principal of the member firm must approve all retail communications before their first use. This pre-use approval ensures that the communication is fair, balanced, and not misleading. The content of the email, which includes the issuer’s name, a factual description of the program, and a link to the prospectus, is designed to comply with SEC Rule 134, which permits such limited announcements without being deemed a prospectus. However, compliance with SEC Rule 134 regarding the content does not eliminate the separate FINRA requirement for procedural approval based on the communication’s classification. The communication is still being sent to retail investors and is therefore subject to the principal approval rules for retail communications. Post-use review is typically associated with correspondence, not retail communication.

Under FINRA Rule 2310, there are specific limits on the compensation that can be received in connection with a public offering of a Direct Participation Program. The rule establishes two primary caps. First, total Organization and Offering Expenses (O&O) cannot exceed \(15\%\) of the gross proceeds of the offering. O&O includes all forms of compensation and expenses related to the offering. Second, and more restrictively, total underwriting compensation cannot exceed \(10\%\) of the gross proceeds. It is critical to understand which expenses fall under the \(10\%\) underwriting compensation limit. This category includes not only the direct sales commissions paid to the selling group but also other payments to FINRA members, such as wholesaling fees and reimbursements for due diligence expenses. In this specific scenario, the components of compensation must be aggregated to test compliance against the \(10\%\) underwriting compensation limit. The underwriting commission is \(8.0\%\). The wholesaling fee paid to an affiliated broker-dealer is considered underwriting compensation and is \(1.5\%\). The reimbursement for bona fide due diligence expenses also counts toward the \(10\%\) underwriting compensation limit and is \(0.75\%\). To determine compliance, these components are summed: \[ 8.0\% \text{ (Commission)} + 1.5\% \text{ (Wholesaling)} + 0.75\% \text{ (Due Diligence)} = 10.25\% \] The resulting total of \(10.25\%\) exceeds the \(10\%\) maximum allowable underwriting compensation under FINRA Rule 2310. Even though the total O&O of \(10.25\%\) is well below the \(15\%\) overall limit, the program is non-compliant because it violates the more specific and lower \(10\%\) cap on underwriting compensation. The violation occurs because the combination of all payments classified as underwriting compensation surpasses the regulatory threshold.

Offering Contingency Analysis: Minimum Subscription Target: $20,000,000 Total Funds Subscribed by Deadline: $19,500,000 Result: The offering failed to meet its minimum contingency ($19,500,000 < $20,000,000). Conclusion: Pursuant to SEC Rule 15c2-4, all subscribed funds must be promptly returned in full to the investors. No compensation or expenses may be deducted. This scenario involves a contingency offering, specifically a "mini-max" offering, which is governed by strict rules to protect investors. SEC Rule 15c2-4 requires that in such offerings, all payments received from investors must be promptly transmitted to a separate bank account or to a qualified, independent escrow agent. These funds are held in trust pending the outcome of the offering contingency. The terms of the offering, as disclosed in the prospectus, dictate the conditions under which the funds can be released. In a mini-max offering, the primary condition is reaching the minimum subscription amount by a specified date. If this condition is not met, the offering is considered unsuccessful. The rule is unambiguous in this situation: the broker-dealer must ensure that the escrow agent promptly returns all subscribed funds directly to the investors. No portion of these funds can be used to pay the issuer, the underwriter, or any other party. This includes any form of underwriting compensation, sales commissions, or reimbursement for organizational and offering expenses. The risk of a failed offering and the associated costs are borne by the sponsor and the broker-dealer, not the investors who subscribed under the specific terms of the contingency.

The representative’s primary obligation is to conduct a reasonable investigation to form a basis for believing the sponsor’s projections are sound. The core of this issue lies in the due diligence requirements mandated by FINRA Rule 2310 and the principles underlying the Securities Act of 1933, particularly the concept of a “reasonable investigation” which is central to the due diligence defense under Section 11. When a representative encounters material information, such as financial projections, that appears inconsistent with independent data, they cannot simply accept the sponsor’s statements. The discrepancy between the sponsor’s 98% occupancy and 10% rent growth projections and the market reality of 90-92% occupancy and 3-4% growth is a significant red flag. A representative’s duty of care requires them to challenge these assumptions. This investigation would involve questioning the sponsor for the basis of their projections, requesting supporting documentation or third party analysis, and independently verifying the claims. The goal is to determine if the sponsor has a justifiable, albeit optimistic, basis for their numbers or if the projections are unsubstantiated and potentially misleading. Simply disclosing the projections as “forward-looking” or relying on the investor’s sophistication is insufficient. The broker-dealer and its representative must have a reasonable basis for recommending the investment, and this basis is formed through a thorough and documented due diligence process. Failure to investigate the discrepancy could expose the firm and the representative to liability for distributing misleading information and failing to meet their suitability and best interest obligations.

The primary compliance issue is the classification and limitation of the “Sponsor-Affiliated Marketing Fee.” According to FINRA Rule 2310(b)(4), there are specific limits on the compensation and expenses related to a public DPP offering. The rule establishes a two-tiered cap on organization and offering (O&O) expenses. First, total O&O expenses are limited to 15% of the gross proceeds of the offering. This 15% includes all forms of compensation. However, within this overall limit, there is a more restrictive sub-cap. The portion of O&O expenses that constitutes underwriting compensation is limited to 10% of the gross offering proceeds. Underwriting compensation is broadly defined and includes not only sales commissions paid to the selling group but also wholesaling fees, due diligence expenses, and other forms of compensation paid to member firms or their affiliates for their role in distributing the securities. A fee paid to an affiliate of the sponsor for marketing the offering is considered a form of underwriting compensation. Therefore, the dealer-manager, in its due diligence capacity, must ensure that this fee is properly categorized as underwriting compensation. The fee must then be aggregated with all other underwriting compensation, and the total must not exceed the 10% limit. Simply including it under the broader 15% O&O expense limit would be a violation if the 10% underwriting compensation sub-cap is breached. The dealer-manager has a due diligence obligation to scrutinize all offering documents and ensure compliance with all applicable FINRA rules, including the proper classification and limitation of all fees and compensation, particularly those involving potential conflicts of interest with program sponsors or their affiliates.

The primary regulatory framework governing this scenario is Regulation D of the Securities Act of 1933, specifically Rule 506(c). This rule provides an exemption from registration for private placements that engage in general solicitation and advertising. However, a critical condition of this exemption is that all purchasers in the offering must be accredited investors. Furthermore, the issuer is required to take reasonable steps to verify that the purchasers are, in fact, accredited investors. An accredited investor is defined in Rule 501 of Regulation D and generally includes individuals with a net worth over one million dollars, excluding the value of the primary residence, or an annual income over two hundred thousand dollars (three hundred thousand dollars with a spouse) for the last two years with the expectation of the same in the current year. While an investor may be sophisticated and have a pre-existing relationship with the representative, sophistication alone does not satisfy the accredited investor standard required for a Rule 506(c) offering. By knowingly soliciting an individual who does not meet the financial thresholds to be an accredited investor for a Rule 506(c) program, the representative is violating the fundamental terms of the offering’s exemption. This action jeopardizes the entire exemption for the issuer. While communication rules under FINRA Rule 2210 are relevant to how the offering is marketed, the most significant violation is the breach of the investor qualification requirements mandated by the Securities Act of 1933 for this specific type of exempt offering.

Calculation: Not applicable. Under FINRA Rule 2310, which governs Direct Participation Programs, there are strict limitations on the expenses that can be charged in connection with a public offering. The rule establishes a two-tiered cap. First, total organization and offering expenses (O&O) are limited to a maximum of 15% of the gross proceeds from the offering. These expenses encompass all costs associated with structuring the program and distributing the securities. Second, a component of the total O&O expenses, known as underwriting compensation, is subject to a more restrictive limit of 10% of the gross proceeds. Underwriting compensation typically includes sales commissions, dealer-manager fees, and any expense allowances paid to the broker-dealer. A critical distinction exists for expenses related to due diligence. FINRA rules recognize the importance of a thorough due diligence investigation by the member firm. Therefore, bona fide, itemized, and accountable due diligence expenses that are reimbursed by the sponsor are not considered part of the 10% underwriting compensation. However, these reimbursed expenses are still considered part of the overall offering costs and must be included when calculating the total 15% organization and offering expense limitation. This carve-out ensures that member firms are not disincentivized from conducting a robust due diligence review due to concerns about exceeding the 10% underwriting compensation cap.

A disproportionate sharing arrangement in an oil and gas direct participation program is a structure where costs and revenues are allocated between the general partner (sponsor) and limited partners (investors) in different percentages. Typically, the investors fund the intangible drilling costs (IDCs), which are immediately tax-deductible expenses like labor, fuel, and drilling mud. The sponsor, in turn, funds the tangible or capital costs, which are not immediately deductible but are depreciated over time, such as for equipment and casing. In exchange for the sponsor covering these non-deductible costs, they receive a disproportionately larger share of the program’s revenues compared to their share of the total costs. This structure is designed to maximize the tax benefits for the limited partners. However, it creates a significant potential conflict of interest. Since the sponsor’s primary cost obligation is tied to capital equipment, and their compensation is a percentage of gross revenue, they have a strong incentive to minimize their capital expenditures. This could lead to the use of lower-quality or less durable equipment, which might reduce the overall production, longevity, and ultimate profitability of the wells. This action would directly harm the limited partners, whose return is dependent on the long-term success of the drilling operations, even though they received the initial tax advantage. A thorough due diligence review must carefully scrutinize this potential misalignment of interests.

The proposed transaction by the sponsor is a prohibited manipulative practice under SEC Rule 10b-9, which governs contingent offerings such as “all-or-none” or “part-or-none” deals. This rule is designed to protect investors by ensuring that their funds are not committed to a project unless a predetermined level of genuine investor interest is achieved. The contingency gives investors assurance that a sufficient amount of capital will be raised to ensure the venture’s viability and that their funds will be promptly returned if this threshold is not met. For a sale to count towards the minimum requirement in an all-or-none offering, it must be a bona fide purchase. A bona fide purchase is one where the investor is truly at risk for the amount of their investment. In the scenario presented, the sponsor’s arrangement to fund a third party’s purchase through a non-recourse loan, which is guaranteed to be repaid from program distributions or by the sponsor directly, means the purchaser has no real economic risk. The purchase is merely a mechanism to create the false appearance that the offering minimum has been successfully met by the deadline. This artificial closing of the offering is a direct violation of Rule 10b-9. The broker-dealer and its representatives have a duty under FINRA Rule 2310 to conduct adequate due diligence and to deal fairly with customers. Participating in or facilitating this scheme would violate these duties. The correct course of action is to recognize the sponsor’s proposal as a prohibited activity, refuse to participate, and if the $10 million minimum is not met through bona fide sales by the specified date, instruct the escrow agent to return all funds to the subscribers as required by the offering terms and SEC Rule 15c2-4.

The core responsibility of a broker-dealer in a direct participation program offering, as mandated by FINRA Rule 2310, is to perform thorough and independent due diligence. This obligation extends to all material aspects of the offering, including the legal and tax opinions provided in the offering documents. A tax opinion is a critical component, as the tax consequences are often a primary motivation for investors in DPPs. When a tax counsel provides a “reasoned” or “more likely than not” opinion, it signifies a lower level of certainty than an “unqualified” opinion. This means the counsel believes that while the proposed tax treatment is likely to be upheld if challenged by the IRS, there is a substantial possibility that it may not be. This type of opinion is a significant red flag for the underwriting broker-dealer. It does not automatically prohibit the firm from participating in the offering, nor does it provide a safe harbor from liability. Instead, it triggers a requirement for heightened due diligence. The firm cannot simply accept the opinion at face value. It must undertake a more intensive investigation into the specific tax issues, understand the basis for the counsel’s reservations, evaluate the potential impact on investors if the tax benefits are disallowed, and ensure these significant risks are clearly, accurately, and prominently disclosed to all potential investors in the offering memorandum and any marketing materials. Failure to do so would be a breach of the firm’s due diligence obligations and could expose it to significant liability under securities laws.

The core of this issue lies in the application of the “at-risk” rules as defined by the IRS, which is a critical concept for evaluating the tax implications of a Direct Participation Program. The at-risk rules limit the amount of losses an investor can deduct to the amount they have personally at risk in the investment. This amount generally includes the cash contributed by the partner, the adjusted basis of any property they contributed, and any partnership liabilities for which the partner is personally liable, known as recourse debt. Crucially, non-recourse debt, for which the partner has no personal liability, does not typically increase a partner’s at-risk amount. The lender’s only remedy in case of default is to seize the collateral securing the loan. However, there is a significant and specific exception to this rule for real estate activities. A special provision allows “qualified non-recourse financing” secured by real property to be included in the partner’s at-risk basis. This exception is strictly limited to financing related to the activity of holding real property. The communication in the scenario involves a developmental oil and gas drilling program, not a real estate program. Therefore, the special exception for qualified non-recourse financing does not apply. Stating that a non-recourse loan in an oil and gas program increases an investor’s at-risk basis is a material misrepresentation of the program’s tax benefits. This violates FINRA Rule 2210, which requires all communications with the public to be fair, balanced, and not misleading. Misstating potential tax deductions is a significant violation of this standard.

The core issue in this scenario revolves around the concept of phantom income, a significant risk in certain direct participation programs, particularly equipment leasing and some real estate programs that use accelerated depreciation. In the initial years of such a program, large non-cash depreciation deductions can shelter the cash distributions from taxes, making the investment appear highly tax-efficient. However, these deductions reduce the asset’s cost basis. When the asset, in this case, the leased equipment, is eventually sold, the gain is calculated as the difference between the sale price and the now very low adjusted basis. This can result in a large, taxable gain. The problem arises because the actual cash proceeds from the sale might be used to pay off remaining partnership debt or be retained for other purposes, meaning the investor receives a large K-1 reporting taxable income but may not receive a corresponding cash distribution to pay the taxes on that income. This is phantom income. Under FINRA Rule 2310, a representative has a due diligence obligation to understand the full economic consequences of a program. Furthermore, under FINRA Rule 2111 and Regulation Best Interest, it is critical to disclose such a material risk to the client, as it could directly contradict the client’s stated objective of receiving tax-sheltered cash flow over the life of the investment. Failing to explain this complex tax consequence would be a significant breach of the representative’s duties.

The core issue is the classification and handling of the proposed communication under FINRA Rule 2210. The plan to send an email to over 300 prospective clients means the communication is defined as “retail communication.” FINRA Rule 2210 defines retail communication as any written, including electronic, communication that is distributed or made available to more than 25 retail investors within any 30 calendar-day period. A prospective client, even if believed to be an accredited investor, is considered a retail investor for the purposes of this definition. According to FINRA Rule 2210(b)(1), a registered principal of the member firm must approve each retail communication before the earlier of its use or filing with FINRA’s Advertising Regulation Department. This pre-use approval is a fundamental supervisory requirement. The fact that the offering is conducted under SEC Regulation D, Rule 506(c), which permits general solicitation and advertising, does not exempt the firm or its representatives from their obligations under FINRA’s conduct rules. The SEC rule governs the registration exemption for the security itself, while the FINRA rule governs the conduct of the member firm and its associated persons in communicating with the public. Therefore, the allowance of general advertising under the Securities Act of 1933 does not remove the requirement for principal approval under FINRA rules. The content of the email, which highlights benefits without a balanced presentation of risks, further underscores the need for stringent supervisory review by a qualified principal to ensure the communication is fair, balanced, and not misleading.

The calculation is based on the gross proceeds of the offering, which is $20,000,000. FINRA Rule 2310 imposes specific limits on the compensation and expenses related to public direct participation program offerings. First, we determine the maximum allowable Organization and Offering (O&O) expenses. This is limited to 15% of the gross offering proceeds. \[\$20,000,000 \times 0.15 = \$3,000,000\] So, the total of all O&O expenses cannot exceed $3,000,000. O&O expenses include both underwriting compensation and bona fide issuer expenses, such as legal, accounting, and printing costs. Second, we determine the maximum allowable underwriting compensation. This is a subset of the O&O expenses and is limited to 10% of the gross offering proceeds. \[\$20,000,000 \times 0.10 = \$2,000,000\] Underwriting compensation includes commissions, wholesaling fees, and reimbursements for due diligence expenses. Now, we analyze the proposed fee structure. The underwriting commission is $1,800,000 and the reimbursed due diligence expenses are $200,000. We must add these together to find the total underwriting compensation. \[\$1,800,000 + \$200,000 = \$2,000,000\] This amount is exactly equal to the 10% limit for underwriting compensation, so it is compliant. Next, we calculate the total O&O expenses by adding the total underwriting compensation to the bona fide issuer fees. The issuer’s legal and accounting fees are $600,000. \[\$2,000,000 \text{ (Total Underwriting Comp)} + \$600,000 \text{ (Issuer Fees)} = \$2,600,000\] This total O&O expense of $2,600,000 is less than the maximum allowable O&O of $3,000,000 (the 15% cap). Since both the 10% limit on underwriting compensation and the 15% limit on total organization and offering expenses are satisfied, this fee structure is permissible under FINRA rules. It is critical for a member firm to verify that both caps are respected independently.

The core regulatory duty of a broker-dealer acting as a dealer-manager for a Direct Participation Program is to conduct thorough and independent due diligence. This responsibility is outlined in FINRA Rule 2310. The rule requires the member firm to have a reasonable basis for believing that all material facts are adequately and accurately disclosed in the offering documents provided to potential investors. In this scenario, the discovery of a novel, unproven technology for the program’s core operations and a qualified tax opinion are significant material facts. A qualified tax opinion, by its nature, indicates that legal counsel is not fully confident in the stated tax consequences, which is a major risk for investors seeking specific tax benefits like the deduction of intangible drilling costs. A dealer-manager cannot simply defer to the sponsor’s representations or the presence of a third-party opinion, especially a qualified one. The firm’s independent duty is to scrutinize these red flags, assess the heightened risks they represent, and ensure that these risks—including the uncertainty of the technology’s success and the potential loss of anticipated tax benefits—are prominently, clearly, and completely disclosed in all offering materials and communications. Failure to do so would mean the firm has not established a reasonable basis for the offering and would result in communications that are not fair and balanced.