Series 22 – Direct Participation Programs Representative Exam Key Study Note Set Two

FINRA Rule 2210 mandates pre-use approval by a registered principal for any retail communication concerning direct participation programs (DPPs). This requirement is particularly stringent due to the complex nature and potential risks associated with DPPs. The approval must encompass not only the overall content and claims made in the communication but also specific elements such as projections of performance, tax implications, and the suitability of the DPP for different investor profiles. The principal’s approval signifies a review for accuracy, fair balance, and absence of misleading information, ensuring compliance with regulatory standards and investor protection. Failure to obtain this approval constitutes a violation of FINRA rules and can lead to disciplinary actions.

A dealer or manager in a DPP syndication has a critical due diligence responsibility to ensure the accuracy and completeness of information provided to potential investors. This includes a thorough review of 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, as highlighted in FINRA Rule 2310(b)(3) and SEC regulations. Failure to conduct adequate due diligence can result in significant liabilities under Section 11 and 12 of the Securities Act of 1933, exposing the dealer or manager to lawsuits from investors who suffer losses due to misrepresentations or omissions in the offering materials.

Regulation D, particularly Rule 506, offers an exemption from the registration requirements of the Securities Act of 1933 for certain private placements of securities, including DPPs. To qualify for this exemption, the offering must meet specific conditions. There is no limit to the amount of capital that can be raised. The issuer must reasonably believe that there are no more than 35 non-accredited investors. The issuer is not required to provide any specific information to accredited investors. However, the issuer must provide non-accredited investors with disclosure documents that are similar to those used in registered offerings. The issuer must be available to answer questions by prospective purchasers. These conditions ensure that the offering is made only to investors who have the knowledge and resources to evaluate the investment opportunity and that all investors have access to sufficient information to make an informed decision. Failure to comply with these conditions can result in the loss of the exemption and potential legal liabilities.

FINRA Rule 4512 mandates that member firms maintain specific customer account information, including the customer’s name, address, tax identification number, and other essential details. This rule is closely linked to FINRA Rule 2090, the “Know Your Customer” rule, which requires firms to make reasonable efforts to obtain and retain essential facts about each customer. Furthermore, these rules intersect with the SEC’s Regulation S-P, which governs the privacy of consumer financial information and the safeguarding of personal information. Together, these regulations create a framework that ensures firms collect necessary customer data, verify its accuracy, protect its confidentiality, and use it appropriately for suitability determinations and compliance with anti-money laundering regulations.

The Employee Retirement Income Security Act of 1974 (ERISA) imposes significant fiduciary responsibilities on plan administrators of employer-sponsored retirement plans. If a plan allows investments in DPPs, the administrators must ensure that these investments are prudent and in the best interests of plan participants. This includes conducting thorough due diligence on the DPPs, considering their suitability for the plan’s investment objectives and risk profile, and monitoring their performance. The potential risks to plan participants include illiquidity, complexity, and the potential for losses due to mismanagement or fraud. Failure to meet these fiduciary duties can result in legal liabilities for the plan administrators.

FINRA Rule 2111 (Suitability) and SEC Regulation Best Interest (Reg BI) significantly impact the recommendations a registered representative can make regarding DPPs. These regulations require that recommendations be in the customer’s best interest and suitable based on their investment profile. To demonstrate compliance, representatives must consider factors such as the customer’s financial situation, investment objectives, risk tolerance, and liquidity needs. For DPPs, this includes assessing the customer’s ability to understand the complex risks associated with these investments, their need for tax benefits, and their capacity to bear potential losses. Representatives must also disclose all material facts about the DPP, including fees, risks, and potential conflicts of interest.

FINRA Rule 2210(c)(6) mandates pre-filing of retail communications concerning DPPs with FINRA’s Advertising Regulation Department. This requirement is triggered if the communication includes projections of performance or contains a recommendation. The filing must occur at least 10 business days prior to first use. This pre-filing requirement aims to ensure that projections are reasonable and substantiated, and that recommendations are suitable for the intended audience. The rule is designed to protect investors from misleading or unsubstantiated claims. Furthermore, even if pre-filing is not required, firms must maintain records of all communications for a period of three years from the date of first use, as stipulated by FINRA Rule 2210(b)(4). This allows for subsequent review by regulators.

A dealer or manager participating in a DPP syndication has a significant due diligence responsibility. This includes a thorough review of the 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. FINRA Rule 2310(b)(3) emphasizes the need for reasonable grounds to believe that the information provided by the sponsor is accurate and complete. Furthermore, Sections 11 and 12 of the Securities Act of 1933 impose civil liabilities for false registration statements and prospectuses, respectively, reinforcing the importance of thorough due diligence to avoid potential legal repercussions. Failure to conduct adequate due diligence can result in disciplinary actions by FINRA and potential lawsuits from investors.

Regulation D provides exemptions from the registration requirements of the Securities Act of 1933, allowing companies, including DPPs, to raise capital without the extensive disclosures required in a registered offering. Rule 504 allows for offerings up to $5,000,000 within a 12-month period, with limited restrictions on the number and type of investors. Rule 506, on the other hand, has no dollar limit but restricts sales to accredited investors and, in some cases, a limited number of sophisticated non-accredited investors. Both rules require the filing of a Form D with the SEC. These rules balance the need for capital formation with investor protection by limiting the types of investors who can participate and requiring disclosure of material information. Rule 506(b) requires that non-accredited investors be sophisticated, meaning they have sufficient knowledge and experience in financial and business matters to evaluate the merits and risks of the prospective investment.

ERISA (Employee Retirement Income Security Act of 1974) governs employer-sponsored retirement plans. When these plans invest in DPPs, several considerations arise. The “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 necessitates a thorough understanding of the risks and potential returns of the DPP. Furthermore, DPPs can generate unrelated business taxable income (UBTI) if the partnership regularly carries on a trade or business that is unrelated to the plan’s exempt purpose. UBTI is taxable to the retirement plan, potentially reducing returns. Fiduciaries must carefully evaluate the potential for UBTI and its impact on the plan’s overall performance. Additionally, ERISA imposes strict reporting and disclosure requirements on plan fiduciaries.

The “Know Your Customer” (KYC) rule, as outlined in FINRA Rule 2090, requires broker-dealers to use reasonable diligence to know and retain the essential facts concerning every customer and concerning the authority of each person acting on behalf of such customer. This includes understanding the customer’s financial situation, investment objectives, and risk tolerance. For DPPs, this is particularly important due to their illiquidity and complexity. Regulation S-P (Privacy of Consumer Financial Information and Safeguarding Personal Information) further protects customer information by requiring firms to provide initial and annual privacy notices, and to implement safeguards to protect nonpublic personal information. These regulations work together to ensure that firms understand their customers and protect their sensitive data, promoting responsible investment practices.

FINRA Rule 2111 and Regulation Best Interest (Reg BI) establish suitability requirements for recommending investments, including DPPs. Rule 2111 requires that a recommendation be suitable based on the customer’s investment profile. This includes a “reasonable basis” to believe the investment is suitable for at least some investors, “customer-specific” suitability based on the individual customer’s profile, and “quantitative suitability,” ensuring that a series of recommended transactions are not excessive or unsuitable when considered together. Reg BI goes further, requiring firms to act in the customer’s best interest and not put their own interests ahead of the customer’s. This involves understanding the risks of the DPP, the customer’s investment objectives, and ensuring that the recommendation is the best available option for the customer, considering factors like cost and complexity.

FINRA Rule 2310 mandates specific disclosures regarding DPPs, including the sources of cash distributions to investors. These disclosures are crucial for investors to understand whether distributions are derived from operating income, capital gains, return of capital, or other sources. Distributions from operating income indicate a financially healthy program, while distributions representing a return of capital suggest that the program is returning investors’ original investment, which may not be sustainable in the long term. Misleading or inadequate disclosure of distribution sources can violate FINRA rules and subject the firm to disciplinary action. Furthermore, accurate disclosure allows investors to make informed decisions about reinvesting or holding their investment in the DPP. The method of account statement reporting, whether public or private, also impacts the accessibility and transparency of this information.

FINRA Rule 2310(b)(3) mandates that broker-dealers have reasonable grounds to believe that all material facts are adequately disclosed and provide the basis for evaluating the DPP. This necessitates a thorough due diligence process, which is heightened in Regulation D offerings due to their unregistered nature and reliance on exemptions from SEC registration under the Securities Act of 1933, specifically Section 4(a)(2) for transactions not involving a public offering. Unlike publicly registered offerings where the SEC reviews the registration statement, Regulation D offerings place the onus of due diligence squarely on the broker-dealer. This includes verifying material statements and risk factors in the offering documents, ensuring compliance with exemption rules (Rules 504 and 506 of Regulation D), scrutinizing financial data and assets, and thoroughly investigating the management’s background and prior performance. Assumptions in offering forecasts or projections must be critically assessed, and the reasonableness of fees and the intended use of proceeds must be validated. Furthermore, the broker-dealer must obtain an opinion from tax counsel regarding the tax implications of the DPP. Specific areas of scrutiny include the economic soundness of the program, its basic objectives, the valuation and characteristics of specified assets, the sponsor’s track record, sources of capital, and anticipated returns on investments. Liquidity provisions and dividend reinvestment plans should also be examined. The due diligence process must be documented, and the broker-dealer must be prepared to demonstrate the basis for its belief that the DPP is suitable for its customers, considering their investment objectives, financial situation, and needs, as per FINRA Rule 2111. Failure to conduct adequate due diligence can result in regulatory sanctions and civil liabilities under Section 12 of the Securities Act of 1933.