Corporate Governance

Broker Duties and FINRA's Regulatory Notice 10-22

By Ashley Dietrich

Brokers, in selling securities to customers, have certain duties and obligations.  These were the subject of Regulatory Notice issued by FINRA earlier in the Summer. 

Regulatory Notice 10-22 creates no new law but reminds broker-dealers of two things when recommending an investment sold without registration under Regulation D.  These are the duty to conduct reasonable investigations and to perform investor suitability requirements.  Both require, among other things, the acquisition of basic information about the issuer selling the securities. 

Broker-dealers have a duty to perform reasonable investigations "concerning that security and the issuer's representations about it" when recommending Regulation D offerings to investors.  The nature of the investigation "depends, among other factors, upon the nature of the recommendation, the role of the broker in the transaction, its knowledge of and relationship to the issuer, and the size and
stability of the issuer."  The duty is not a discretionary duty; conducting a reasonable investigation is obligatory.  Moreover, to the extent lacking "essential information about an issuer or its securities when it makes a recommendation," the broker must "disclose this fact as well as the risks that arise from its lack of information."

Finally, while the broker often relies on information obtained by the issuer of the securities, the Regulatory Notice calls for caution in doing so.  As FINRA describes:

• In general, however, a BD 'may not rely blindly upon the issuer for information concerning a company,'14 nor may it rely on the information provided by the issuer and its counsel in lieu of conducting its own reasonable investigation.  While BDs are not expected to have the same knowledge as an issuer or its management, firms are required to exercise a 'high degree of care' in investigating and independently verifying an issuer's representations and claims.16 Indeed, when an issuer seeks to finance a new speculative venture, BDs 'must be particularly careful in verifying the issuer's obviously self-serving statements.'

The Regulatory Notice also reminded brokers of their obligation to conduct a suitability inquiry. The security must be suitable for the specific customer.  As FINRA points out, this requires more than an assessment that the investor meets the standards for accredited investor in Regulation D.

• The fact that an investor meets the net worth or income test for being an accredited investor is only one factor to be considered in the course of a complete suitability analysis. The BD must make reasonable efforts to gather and analyze information about the customer's other holdings, financial situation and needs, tax status, investment objectives and such other information that would enable the firm to make its suitability determination. A BD also must be satisfied that the customer 'fully understands the risks involved and is…able…to take those risks.'

The suitability investigation also requires some knowledge about the company issuing the securities. This includes the company's business prospects, assets, and intended use of the proceeds, as well as a reasonable investigation into any claims being made by the company. 

The Regulatory Notice also sets out circumstances that can raise additional responsibilities for a broker in the context of recommending securities.  These include affiliations with the issuer, participation in the drafting of the private placement memorandum, and the consequences of uncovering red flags.  The Notice also sets out reasonable investigatory practices. 

Full post as published by The Race to the Bottom on August 23, 2010 (boomark / email).