When a firm recommends a private placement, it makes two distinct assertions. The first is about the customer: this is appropriate for you. The second is about the product: this is a legitimate investment that could be appropriate for someone.
The second assertion is the one that requires investigating the offering itself, and it is a firm-level obligation that exists independently of any particular customer relationship. It is also the one most often under-documented.
The obligation
FINRA has addressed this directly in the context of Regulation D offerings, and the position is consistent and clear: a broker-dealer that recommends a private placement must conduct a reasonable investigation of the issuer and the securities it recommends, and may not rely blindly on representations made by the issuer or its counsel.
Two elements of that framing carry weight.
It is an independent investigation. The offering materials are prepared by the party raising the money. They are a starting point for verification, not a substitute for it. Firms that have relied exclusively on sponsor-supplied materials have repeatedly been found not to have satisfied the obligation.
It attaches to recommending, not to selling. A firm that recommends the security has the obligation, regardless of how the transaction is executed.
Additional requirements apply to direct participation programs under FINRA Rule 2310, including on compensation and on the information a member must obtain, covered in FINRA Rule 2310. FINRA Rule 5123 imposes filing requirements on members participating in private placements, and Rule 3110 requires supervisory systems reasonably designed to achieve compliance with all of it.
How Reg BI fits
Regulation Best Interest applies to recommendations of securities to retail customers, requiring the firm to act in the customer best interest without placing its own interests ahead. Its care obligation includes exercising reasonable diligence, care, and skill to understand the product and to have a reasonable basis to believe a recommendation could be in the best interest of at least some retail customers — and that this particular recommendation is in the best interest of this particular customer.
The practical relationship is that product-level understanding is a component of the standard rather than a separate regime running alongside it. The two-level structure survives: understand the product, then match it to the customer. Reg BI raised the standard applicable to the second step and made explicit an expectation about the first.
Investment advisers reach a similar place by a different route, owing fiduciary duties under the Advisers Act that include a duty of care in recommending investments.
Because the interaction of these frameworks continues to develop through guidance and examination findings, firms should work from current sources rather than from a settled summary.
What a reasonable investigation covers
There is no prescribed checklist, and the scope varies with the offering complexity and risk. In practice a defensible investigation addresses:
The issuer and its principals. Who they are, their experience, their financial condition, their regulatory and litigation history, and independent verification of their claims about themselves.
The offering. The PPM and governing documents read directly, the structure, the exemption relied upon, and whether the compliance perimeter appears to be maintained. See private placement compliance.
The assets. What is actually being bought, how it was underwritten, and whether the projections rest on assumptions that can be examined.
Compensation. All of it — to the firm, to the advisor, to the dealer manager, and to sponsor affiliates. Unusual or unexplained compensation arrangements are a recognised red flag.
The track record, with attention to selection and to whether it is verified. See evaluating a sponsor track record.
Risks, including the ones the offering materials treat lightly — concentration, illiquidity, leverage, key person exposure, and conflicts.
Consistency. Whether the marketing, the PPM, the legal documents, and any financial statements describe the same arrangement. This is where a large share of significant findings originate.
Red flags
FINRA guidance describes circumstances that should prompt heightened inquiry. The recurring themes:
- Inconsistencies within or between offering documents
- Compensation arrangements that are unusual, opaque, or difficult to explain
- Claims that cannot be independently verified
- Principals with disciplinary, regulatory, or bankruptcy histories
- Projections presented without supportable assumptions
- Auditor or service provider changes without explanation
- Pressure to complete a placement quickly, or resistance to routine questions
The important point about red flags is procedural: encountering one generally requires resolving it, not noting it and proceeding. A firm that identified a concern, documented it, and sold the offering anyway without resolution is in a materially worse position than one that never looked.
Documentation
The investigation is only as useful as the record of it. A defensible file typically contains:
- What was reviewed, with dates
- What was independently verified, and how
- What questions were asked and what answers were received
- Any third-party reports obtained, together with the firm own assessment of them
- Red flags identified and how each was resolved
- Who conducted the review and their qualifications
- The platform decision and its reasoning, including any limitations imposed — such as concentration caps or restrictions on which customers may be recommended the product
- The refresh cycle for continuing offerings
Point four is where firms most often fall short. A third-party report in the file, with no record of the firm own engagement with it, documents that a report was purchased rather than that an investigation was conducted.
Ongoing, not one-time
For continuously offered products — non-traded REITs, perpetual BDCs, continuing DST programs — the offering remains live for years. Sponsor circumstances change, portfolios change, distribution coverage changes, and repurchase programs get constrained.
A diligence file completed at onboarding and never revisited describes an offering that no longer exists. Firms should define a refresh cycle and a set of events that trigger re-review outside it, and should keep the record of each refresh.
Why this matters beyond compliance
The regulatory framing is the reason firms must do this. The better reason to do it well is that reasonable-basis diligence is the only point in the chain where anyone independent examines the product before it reaches investors who cannot examine it themselves.
A firm that performs the function seriously is doing the thing the framework exists to accomplish. A firm that maintains a file is satisfying the framework. The two overlap substantially, and they are not identical, and the difference tends to show up in exactly the offerings where it matters most.
This guide is educational and general; it is not legal or compliance advice. Regulatory obligations are fact-specific and evolving; consult qualified counsel and current FINRA and SEC guidance.
Frequently Asked Questions
What is reasonable-basis diligence?
The obligation of a firm recommending a security to have a reasonable basis to believe the recommendation is appropriate for at least some investors, based on a reasonable investigation of the product itself. It is a product-level obligation, distinct from whether a recommendation suits a particular customer.
Does a broker-dealer have to investigate a private placement?
Yes. FINRA has stated that a broker-dealer recommending a Regulation D offering must conduct a reasonable investigation of the issuer and the securities, and cannot rely blindly on representations by the issuer or its counsel. FINRA Rule 2310 imposes additional requirements for direct participation programs.
How does Regulation Best Interest affect this?
Regulation Best Interest requires a broker-dealer making a recommendation to a retail customer to act in the customer best interest, and its care obligation includes understanding the product and having a reasonable basis to believe the recommendation could be in the best interest of at least some retail customers. Product-level understanding is a component of the standard, not a separate regime.
What are red flags that require further investigation?
FINRA guidance describes circumstances that should prompt heightened inquiry, including inconsistencies in offering materials, unusual or unexplained compensation arrangements, difficulty verifying claims, issuer principals with problematic histories, and projections that are not supported. Encountering a red flag generally requires resolving it rather than proceeding.
Can a firm rely on the issuer materials?
Not exclusively. The obligation is to conduct an independent investigation, and reliance solely on materials prepared by the issuer or its counsel has repeatedly been identified as insufficient. Issuer materials are a starting point for verification rather than a substitute for it.
Sources
- FINRA Regulatory Notice 10-22 (obligation of broker-dealers to conduct reasonable investigations in Regulation D offerings)
- FINRA Rule 2111 (Suitability) and FINRA Rule 2310 (Direct Participation Programs)
- SEC Regulation Best Interest, Exchange Act Rule 15l-1
- FINRA Rule 3110 (Supervision) and FINRA Rule 5123 (private placements)
