Broker-dealers, funding portals, and FINRA’s 2018 examination findings

On December 7, 2018, FINRA released its 2018 Report on Examination Findings. This is the second annual report FINRA has released, and it provides a wealth of information for compliance officers. FINRA notes that it is not an exhaustive review of deficiencies exhibited by broker-dealers, but it does highlight those deficiencies that were significant and frequent. While the report focuses on broker-dealer operations, funding portals should take note as well, as FINRA has imputed certain broker-dealer supervisory and issuer review practices to funding portals under FINRA Funding Portal Rule 200.

The leading issue identified by FINRA was broker-dealers having sufficient compliance programs for suitability determinations under broker-dealer Rule 2111. FINRA notes that a suitability determination for a broker-dealer is composed of three main components: (1) reasonable basis suitability; (2) customer specific suitability; and (3) quantitative suitability. However, before any broker-dealer can make a reasonable basis suitability determination, that broker-dealer must undertake reasonable due diligence and believe that the investment is suitable for at least some investors. Only then can it move on to the other two components.

With regard to funding portals, the funding portal rules do not expressly set out any suitability standards. However, FINRA has the authority to find the funding portal has violated Rule 200 if it fails to undertake reasonable due diligence on par with the reasonable basis suitability component of Rule 2111. For instance, the absence of a reasonable review (e.g., a review that is limited to the statutory requirement to undertake a securities regulatory and background check) may be deemed to be a violation of Rule 200(a) because the funding portal is not complying with obligations to “observe high standards of commercial honor and just and equitable principles of trade.” Alternatively, allowing issuers to make statements that are not supportable may be deemed to be a violation of Rule 200(c) and considered to be a funding portal communication that contains “false, exaggerated, unwarranted, promissory or misleading” statements.

These observations by FINRA are especially relevant in the world of online capital formation where issuers have significant control over the content posted on an online investment platform. In our work and when undertaking independent reviews of the industry, it was not uncommon for us to find: descriptions of securities that were inconsistent with the constitutive documents of the issuer; financial discussions that omit the operations of a predecessor relevant to the current financial condition of the issuer; use of promissory projections that do not include the assumptions that support those projections; failure to disclose that IP relevant to the operations of the issuer are held personally by a founder; conflicts of interest and splitting of time by the management of the issuer; failure to meet basic subscription agreement representations; and numerous other discrepancies or omissions.

For a broker-dealer or funding portal to identify certain issuer statements as problematic, it needs to know the facts about the issuer. That is where CrowdCheck comes in to provide tailored solutions for broker-dealers and funding portals to meet their due diligence obligations. CrowdCheck specializes in objective reports that supplement your own subjective determinations. Additionally, our Bad Actor Report provides a reasonable review necessary to demonstrate compliance with Rule 506(d) of Regulation D, Rule 262 of Regulation A, and Rule 503 of Regulation Crowdfunding. These services can be part of any comprehensive compliance program, giving broker-dealers and funding portals the tools they need to stay compliant.

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