Private placements and their due diligence reviews have come under increased regulatory scrutiny, and for good reason. With recent Securities and Exchange Commission efforts to loosen up the general solicitation requirements for private placements and the mandate of the JOBS Act to facilitate such offerings, we should expect not only an increase in resort to such financing but also a concomitant increase in investor complaints and regulatory scrutiny. Here is a recent FINRA regulatory settlement involving just that area.
For the purpose of proposing a settlement of rule violations alleged by the Financial Industry Regulatory Authority (“FINRA”), without admitting or denying the findings, prior to a regulatory hearing, and without an adjudication of any issue, Sunset Financial Services, Inc. submitted a Letter of Acceptance, Waiver and Consent (“AWC”), which FINRA accepted. In the Matter of Sunset Financial Services, Inc., Respondent (AWC2011026915701, July 17 2013).
Sunset Financial Services has been a FINRA broker-dealer since 1968 and is wholly-owned by Kansas City Life Insurance Company, Inc. Sunset’s primary business is selling mutual funds and variable annuities; and the firm has about 302 branch offices, 504 registered individuals and 197 non-registered individuals. The AWC asserts that Sunset had no prior relevant disciplinary history.
A Private Matter
In 2001, Sunset began selling private placements as an unaffiliated broker-dealer. The firm had delegated nearly all responsibilities relating to private placements to its vice president in charge of products and sales (the “Vice President”) and among his responsibilities were
conducting due diligence;
entering into selling agreements with issuers;
reviewing third-party due diligence reports;
formulating recommendations of private placements; and
monitoring for suitability.
At all times relevant to the AWC, the Vice President, who reported directly to Sunset’s President, was responsible for conducting private placement due diligence prior to approving the contemplated sale of any subject product by the firm’s registered representatives. Approved placements would be placed on the firm’s approved list, which was viewable by registered representatives on an internal website.
The First Fund
In 2004, the Vice President approved the sale of an investment fund acting as a bridge loan lender of short-term mortgages, secured by real property primarily in Arizona and California. This fund was sold as a Reg D private placement, and the fund’s CEO was the son of a Sunset registered representative and supervisor. The fund’s private placement memorandum "PPM" advised that:
"[w]e are in the business of investing in mortgage loans and, as such, we risk defaults by borrowers . . .
. . .
[a]ny failure of a borrower to repay loans or interest on loans will reduce our revenues and your distributions, the value of your units and your interest in the Fund as a whole. . .
A July 2008 third-party due diligence report on the fund provided to Sunset and the Vice President disclosed an increased default rate of about 20% for the loan portfolio. In late September 2008, the fund suspended redemptions due to financial difficulties and also stopped accepting new investors. By May 2009 monthly distributions were suspended.
314 Sunset customer accounts invested some $57 million in this fund from 200 through September 2008, generating about $1,140,000 for Sunset (exclusive of trails).The fund’s sponsor paid Sunset a gross dealer concession of 2% plus trail.
The Second Fund
In early 2009, the sponsor of the first fund launched a second investment fund, which was sold only to accredited investors as a Regulation D private placement. The PPM for this second fund disclosed that the fund’s:
primary focus will be the acquisition of discounted debt from distressed banks and other leveraged financial institutions, and it will target investments available for purchase at substantial discounts to par value.
The AWC asserts that in early 2009, Sunset was aware that a third-party due diligence provider was in the process of researching and drafting a due diligence report on the second fund. Without waiting for the release of that report, Sunset allegedly placed the second fund on its approved list. In questioning that conduct, the AWC notes that the firm:
was aware of the first fund’s financial difficulties;
knew of the common management of both funds;
did not conduct any enhanced due diligence on the second fund despite the presence of red flags indicating the need for greater scrutiny prior to undertaking sale to the firm’s customers; and
was already aware of the red flags attendant to the first fund, with specific reference to the suspended redemptions and monthly distributions.
Another Bottom Line
From May 2009 through December 2009, Sunset sold to 18 investors $750,709 of the second fund, for which it received about $45,042. The fund’s sponsor paid Sunset a gross dealer concession and a non-accountable advertising and due diligence fee of 50 basis points.
The Maligned Checklist
Although Sunset had delegated nearly all due diligence duties to the Vice President, the AWC asserts that the firm had no procedures to follow-up on whether that officer was properly performing his responsibilities. Moreover, it was not until the May 2009 adoption by Sunset of alternative investment procedures that the firm allegedly even had written supervisory procedures in place for private placements. Further, the AWC pejoratively characterized those 2009 procedures as a fairly generic checklist of items such as personnel background, lawsuits, financials, references, and the like – the implication being that the procedures were not reasonably tailored to any specific alternative product, such as a private placement. Finally, the AWC cites the procedures as insufficient in terms of providing for ongoing re-evaluation of previously approved products.
SIDE BAR: It's rarely a good compliance practice to vest "all" responsibility for a given area in one individual because, if nothing else, it exposes that person to regulatory scrutiny that could result in his or her suspension or bar -- a potentially crippling impact for smaller firms. That being said, the reality of modern day Wall Street is that the costs of maintaining supervisory and compliance staffs can be overwhelming for smaller firms and frequently compels the aggregation of too many critical roles on the shoulders of one or a few key personnel. See the Sobel interview linked below.
Too Much Authority
The AWC asserts that Sunset registered representatives periodically contacted the Vice President seeking product recommendations for their customers, and during these conversations, the Vice President made trade recommendations for specific customers – and the recommendations were private placements from the firm’s approved list. The AWC criticized this practice because it alleged that there were no checks or balances on the Vice President's authority, who was simultaneously recommending private placements to customers through his discussions with registered representatives, while at the same time reviewing the suitability of those recommendations.
SIDE BAR: If at all possible, a broker-dealer should segregate the roles of review/supervision from those of recommending sales. The inherent conflicts in such competing duties is obvious and will quickly be seized upon by a regulator, as is demonstrated in this case. As note earlier, however, the economics of smaller firms is such that there is often no meaningful way to avoid this dangerous overlap.
Although Sunset’s written procedures required pre-use approval of sales materials provided to customers, the AWC admonishes the firm for permitting its registered representatives to give pre-approved sponsor-created sales materials to their customers. That practice was criticized because Sunset purportedly relied on its registered representatives to forward any sales material regarding private placements they intended to provide to customers to the firm's compliance department for prior review.
Unfortunately, the AWC alleges that Sunset had no procedure to review or track the issuer materials provided directly to registered representatives, and without reviewing this information, the firm was unable to monitor the dissemination of inaccurate or misleading materials to its salesforce. Moreover, such a lack of oversight could result in the communication of misinformation to customers – in fact, some registered representatives allegedly incorrectly assumed that private placement sales materials sent directly from the issuer to them had already been approved, and therefore provided unapproved materials to customers.
SIDE BAR: All of which explains why many brokerage firms have two large rubber stamps:
APPROVED FOR CUSTOMER DISSEMINATION
FOR INTERNAL USE ONLY. NOT APPROVED FOR CUSTOMER DISSEMINATION
During the relevant period, the AWC alleges that during seminars and office visits, sponsors provided materials directly to Sunset’s registered representatives, and that some of the materials were intended for internal-use only. Notwithstanding, the firm’s supervision was found deficient because of the lack of any policies or procedures regarding the review of such sponsor provided materials.
Summing It All Up
The AWC alleges that Sunset violated NASD Rules 3010 and 2110 and FINRA Rule 2010, by failing to establish and maintain policies and procedures reasonably designed to ensure adequate due diligence was performed for private placements at inception, and on a continuing basis whenever negative information or other red flags occurred. Further, the AWC alleges that Sunset lacked an adequate system for the review of suitability, sales materials and internal use materials relating to private placements.
In accordance with the terms of the AWC, FINRA imposed upon Sunset a Censure; $200,000 fine; and disgorgements of $84,253.03 in gross dealer concessions and due diligence fees plus interest as partial restitution to customers. The AWC also required disgorgement as partial restitution to certain specified clients in the amount of $80,499.48 plus interest.
Bill Singer's Comment
For starters, compliments to FINRA on publishing a comprehensive explanation of the underlying facts and the rationale for this settlement. Although I have often criticized the self regulatory organization for a penchant for hide-and-seek published regulatory settlements and decisions, the Sunset AWC is as close to perfection as I could desire. Instead of conclusory assertions, we have substantial details and a patient effort to explain the shortcomings of policies and procedures.
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