FINRA Series 39 Direct Participation Programs Principal Exam​ Key Study Note

In a “best efforts, all or none” underwriting, the underwriter agrees to sell all of the securities offered, and the offering is canceled if the entire amount is not sold. In a “best efforts, mini-max” underwriting, a specified minimum amount must be sold for the offering to proceed; if the minimum is met, the underwriter continues to sell up to a maximum amount. Rule 10b-9 under the Securities Exchange Act of 1934 prohibits underwriters from representing that an offering is “all or none” or “minimum-maximum” unless funds received are promptly transmitted to an independent escrow account or trust account until the contingency is met. If the contingency is not met, all funds must be promptly returned to investors. This rule ensures that investors’ funds are protected and that the offering is conducted as represented. Failure to comply with Rule 10b-9 can result in SEC enforcement actions and potential liability for the underwriter.

A Dealer Manager in a managed DPP offering has significant due diligence responsibilities. These include verifying material statements in offering documents, confirming compliance with registration/exemption rules, reviewing financial data, investigating management background, checking the issuer’s track record, assessing the reasonableness of forecasts, and evaluating fees. In a public offering, performing thorough due diligence provides a statutory defense under Section 11(c) of the Securities Act of 1933 against liability for false or misleading statements in the registration statement. In a private offering, while a statutory defense isn’t available, due diligence helps avoid fraud charges. The level of scrutiny may differ, with public offerings generally requiring more extensive verification due to increased regulatory oversight and potential liability. Regardless, the Dealer Manager must exercise reasonable care to ensure the accuracy and completeness of the offering disclosures.

Registered individuals acting as wholesalers for DPP offerings face several compliance requirements. First, they must be supervised by their firm, as mandated by FINRA Rule 3110, ensuring their activities align with regulatory standards. Second, their involvement may cause their member firm to be deemed an underwriter, subjecting them to underwriter’s liability under Section 11 of the Securities Act of 1933 for any material misstatements or omissions in the offering documents. Third, all wholesaling compensation and expenses must be processed through the member firm’s books, ensuring transparency and accountability. Finally, member firms must ensure compliance with FINRA’s non-cash compensation guidelines (e.g., Rule 2310(c)) and training/education restrictions, preventing conflicts of interest and ensuring that sales incentives do not compromise investor suitability.

Sales compensation in public DPP offerings is subject to strict limitations. Under FINRA Rule 2310, total underwriting compensation, including cash and non-cash items, is limited to 10% of the gross dollar amount of securities sold, plus up to 0.5% for reimbursement of bona fide due diligence expenses. Additionally, organization and offering expenses are capped at 15% of the proceeds. These limits are enforced through FINRA Rule 5110, which requires detailed filings of underwriting terms and arrangements, allowing FINRA to review and ensure compliance. Violations can lead to disciplinary actions, including fines, suspensions, and even expulsion from FINRA. The purpose of these limits is to protect investors by preventing excessive compensation that could incentivize aggressive sales tactics or reduce the funds available for the DPP’s stated purpose.

SEC Rule 15c2-4 governs the transmission and maintenance of payments received in DPP underwritings. It mandates that broker-dealers promptly transmit investor funds to an independent escrow agent or trust account until certain conditions of the offering are met (e.g., minimum subscription levels). The funds must be held in a segregated account, and if the offering contingency is not satisfied, all funds must be promptly returned to investors. Failure to comply with Rule 15c2-4 can result in significant liabilities for broker-dealers. These may include SEC enforcement actions, such as fines, cease-and-desist orders, and suspensions. Additionally, broker-dealers may face civil lawsuits from investors who have suffered losses due to the improper handling of funds. The rule aims to protect investors by ensuring that their funds are safeguarded and used only for the intended purpose of the offering.

Section 11 of the Securities Act of 1933 imposes civil liabilities on various parties, including underwriters, for material misstatements or omissions in a registration statement. In the context of DPP offerings, this means that broker-dealers involved in the underwriting process can be held liable to investors who purchase securities based on a false or misleading registration statement. To mitigate this risk, broker-dealers must conduct thorough due diligence to verify the accuracy and completeness of the information in the registration statement. This includes reviewing financial data, investigating management, and confirming compliance with applicable regulations. A “reasonable investigation” provides a defense against liability. Furthermore, broker-dealers should maintain detailed records of their due diligence efforts to demonstrate that they exercised reasonable care. Compliance with SEC Guide 5 (for real estate programs) or SEC Guide 4 (for oil and gas programs) is also crucial.

SEC Rule 15c2-4 governs the transmission and maintenance of payments received in underwritings, including those for DPPs. A broker-dealer can temporarily hold investor funds if the offering is contingent, such as an all-or-none or mini-max offering. The funds must be promptly deposited into a separate bank account, as agent or trustee for the investors, until the contingency is met. If the contingency is not met, all funds must be promptly returned to the investors. The rule aims to protect investors by ensuring that their funds are used for the intended purpose and are returned if the offering is unsuccessful. Failure to comply can result in sanctions.

Section 11 of the Securities Act of 1933 imposes civil liabilities on anyone involved in the preparation of a registration statement that contains false or misleading information. This includes issuers, underwriters, and broker-dealers. Investors who purchase securities based on a false registration statement can sue for damages. However, Section 11(c) provides a “due diligence” defense. If a broker-dealer can demonstrate that they conducted a reasonable investigation and had reasonable grounds to believe that the statements in the registration statement were true and complete, they may avoid liability. This defense underscores the importance of thorough due diligence in DPP offerings. Section 11(d) pertains to the calculation of damages.

In a managed DPP offering, the dealer manager plays a central role in the syndication process. Responsibilities include performing due diligence on the offering, soliciting and allocating retail participation by other broker-dealers, maintaining books and records, assisting the issuer in planning and preparation, coordinating investor relations, and entering into a dealer/manager agreement with the program sponsor. The dealer manager’s due diligence obligations are generally more extensive than those of other participating broker-dealers, as they are responsible for overseeing the entire offering. Potential conflicts of interest arise if the dealer manager is an affiliate of the sponsor, necessitating heightened scrutiny of the offering’s terms and disclosures. FINRA Rule 2310 outlines specific requirements for DPPs, including suitability determinations and disclosure of conflicts.

FINRA Rule 2310 sets forth specific suitability requirements for DPP investments, recognizing their unique risks and illiquidity. Before recommending a DPP, a registered representative must have reasonable grounds for believing that the investment is suitable for the customer based on their financial situation, investment objectives, and risk tolerance. The rule requires firms to perform due diligence to understand the DPP’s features, costs, and risks. Representatives must also make reasonable efforts to ascertain critical customer information, including net worth, income, and investment experience. The rule aims to protect investors from unsuitable DPP recommendations by ensuring that representatives understand both the product and the customer.

FINRA imposes limits on sales compensation in public DPP offerings to prevent excessive fees and protect investors. Underwriting compensation is generally limited to 10% of the gross dollar amount of securities sold, plus up to 0.3% for reimbursement of bona fide due diligence expenses. This limitation affects the structuring of underwriting agreements by requiring broker-dealers to carefully manage their expenses and compensation arrangements. It can also impact the overall profitability of DPP offerings, as broker-dealers must balance the need to generate revenue with the regulatory constraints on compensation. FINRA Rule 5110 provides further guidance on underwriting terms and arrangements.

The integration doctrine under Regulation D addresses the potential for issuers to circumvent registration requirements by dividing a single offering into multiple offerings, each of which individually qualifies for an exemption. If offerings are integrated, they are treated as a single offering, and all requirements for a single exemption must be met. Rule 502(a) provides a safe harbor: offerings more than six months apart are generally not integrated. To avoid integration, issuers should ensure that offerings are separated by at least six months, involve different classes of securities, are made for different purposes, and involve different consideration. Careful planning is essential to maintain the availability of Regulation D exemptions.

A Dealer Manager in a DPP offering has significant due diligence responsibilities to ensure the accuracy and completeness of offering disclosures. This includes verifying all material statements in the offering documents, confirming compliance with registration/exemption rules, reviewing financial data, investigating management background, checking the issuer’s track record, reviewing the reasonableness of assumptions in forecasts or projections, and evaluating all fees and other distributions of proceeds. Failure to perform adequate due diligence can lead to significant liabilities. Under Section 11 of the Securities Act of 1933, a statutory defense is available for public offerings if reasonable care is exercised. For private offerings, thorough due diligence helps avoid fraud charges. FINRA also emphasizes the importance of due diligence in its rules and regulations, particularly in Rule 2310 regarding DPPs, which requires members to have reasonable grounds to believe that the DPP is suitable for the investor. Inadequate due diligence can result in disciplinary actions by FINRA, including fines, suspensions, and other penalties, as well as potential civil liabilities to investors who suffer losses due to misrepresentations or omissions in the offering documents. The Dealer Manager’s role is crucial in protecting investors and maintaining the integrity of the DPP market.

FINRA Rule 5130, concerning Restrictions on the Purchase and Sale of Initial Equity Public Offerings, aims to protect the integrity of the IPO market by preventing certain individuals and entities from taking unfair advantage of access to new issues. The rule generally prohibits restricted persons, including member firms, their associated persons, and certain related individuals, from purchasing IPOs. While DPPs are not explicitly exempt from Rule 5130, certain exceptions may apply depending on the structure and purpose of the DPP. For example, the issuer-directed securities exception allows an issuer to direct sales of the IPO to specific individuals, which could include participants in a DPP if the DPP is affiliated with the issuer and the sales are genuinely directed by the issuer. Additionally, the anti-dilution provision may allow existing investors in a DPP to maintain their proportionate ownership in the company through the purchase of IPO shares. Stand-by purchasers and undersubscribed offerings may also present opportunities for DPP participants to acquire IPO shares under specific circumstances. However, it is crucial to analyze each situation carefully to ensure compliance with Rule 5130, as violations can result in significant penalties, including fines and disgorgement of profits. Member firms must maintain detailed records and documentation to demonstrate compliance with the rule and justify any exceptions claimed.