Regulators Eye the Role of Investment Wholesalers in Providing Misleading Disclosures to Investors


The Financial Industry Regulatory Authority (FINRA) is showing stepped-up interest in the role of broker-dealers and individuals that act as wholesalers in the sale of private (Reg D) offerings that clients and often brokers do not fully understand. (See InvestmentNews article by Bruce Kelly entitled “Finra eyes wholesalers’ role in vending.”

According to FINRA Rule 5122, a broker-dealer acts as a wholesaler if it is subject to an agreement to “sell through its affiliate broker-dealers less than 20% of the securities in [a private] offering.” In other words, the wholesaler sells less than 20% of the offering directly to retail investors, and works to sell the rest through selling agreements with third-party broker dealers. The wholesaler is typically a “captive” broker-dealer” ? i.e., a captive of the issuer in that its only products are the securities created by the issuer of the private placement.

“FINRA Rule 5122 was developed in response to abuses in the sale of private placements issued by broker-dealers’,” according to FINRA (see FINRA Regulatory Notice 11-04). Rule 5122 requires, subject to certain exemptions, that broker-dealers that participate in private placements do three things:

  • Disclose to investors in an offering document the intended use of the money they raise from investors, including how much is actually invested versus how much is paid to the broker-dealers as compensation;
  • File the offering document with FINRA; and
  • Pay themselves no more than 15% of the money raised from investors ? i.e., at least 85% of investors’ money must be used for the business purposes described in the offering document.

Among the exemptions that excuse broker-dealers from doing those three things is an exemption for wholesalers.

FINRA published this Notice in January 2011 to request comments regarding its proposal to amend Rule 5122 to eliminate the exemption for wholesalers. Comments from broker-dealers poured in. The exemption has not been eliminated.

According to the article, FINRA is concerned about misinformation flowing from wholesalers to the sellling broker-dealers and their registered representatives, who are responsible for explaining to potential investors how the investment works and what the risks are. How could they do that if they receive incorrect information from the wholesalers?

According to FINRA, two fairly recent cases in which wholesalers sold private placements to investors illustrate the problem. In SEC v. Sunwest Management, Inc., the SEC found that Sunwest and its affiliated broker-dealer that acted as wholesaler in a private placement that raised over $300 million from more than 1,300 investors in TIC investments made false promises of high annual returns while concealing that proceeds from new investors were commingled to pay other investors.

Similarly, in State of Idaho v. Douglas Swenson, et. al., the State of Idaho found that a wholesaler affiliated with the issuer, raised over $1 billion while defrauding investors, commingling funds and omitting material information. (FINRA Regulatory Notice 11-04, n. 13.)

“In cases we’ve looked at, sometimes these products are so easy to sell because they promise more return with less risk. They’re easy to sell, and they take over the [broker-dealer’s] platform, and the firm doesn’t truly understand them at a base level,” J. Bradley Bennett, executive vice president for enforcement at FINRA, was quoted as saying.

Mr. Bennett was a panelist for the Securities Industry and Financial Markets Association’s compliance and legal society’s annual seminar, which was held recently.

Noting that FINRA does not have any enforcement cases pending against wholesalers, Mr. Bennett was quoted as saying:

“Wholesalers provide a lot of information on these products, and [a wholesaler] may be the first interaction” that brokers have with products. “We just want to understand the process and where the information train is coming from. ‘ If we see, at the end, where investors don’t appear to understand the product, or the sales force doesn’t understand the product, the logical question to ask is: Why?”

Page Perry is an Atlanta-based law firm with over 170 years of collective experience maintaining integrity in the investment markets and protecting investor rights.