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4 Lessons to Learn from a Recent FINRA Enforcement Action

Post on: November 27, 2017 | Tim Boykin | 0



FINRA recently filed a disciplinary proceeding against a large southeastern broker dealer and two of its principals. The principals, through the broker-dealer and other related entities they owned, bought interests in saltwater disposal wells and allegedly sold them at an exceedingly marked up price to investors. The efficacy of the claims and the fault of the parties are still being litigated and some of the counts are specific to broker-dealers. Still, there are a few key lessons for those raising capital and their investors.

1. Know when you are selling securities

This is a concept we continue to observe market participants address incorrectly, and sometimes illegally, in the market. Here, the reseller sold well interests as “real estate.” As FINRA alleges, however:

  • “the investors purchased the interests with the expectations that they would receive profits from the successful operation of the wells”;
  • the management agreement “rendered the investors passive and obligated Fund Management to exercise ‘sole discretion and responsibility . . . to determine, supervise, undertake, operate and manage [the well] on behalf of [the investors]; and
  • “the investors wholly relied upon the efforts of the manager and the well operator for the success of, and profits resulting from, their investments.”

FINRA’s analysis here tracks the Howey Test that courts use to determine whether a real estate interest is a security. If an investor expects profits from the efforts of a third party (and not through the investor’s own efforts) from the purchase of an interest, that interest may be a security. Unregistered securities activity in violation of Rule 15(a) is on the radar for regulatory bodies. In this case, FINRA alleges the broker-dealer principals allowed the reseller to act as an unregistered broker. For unregistered entities and individuals, the SEC is the regulatory entity bringing enforcement actions.

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2. Be transparent about the parties involved and what are they doing

There were several key entities involved in the sale of the well interests to investors:

  • Registered representative
  • Managing broker-dealer
  • Fund
  • Fund manager
  • Well interest re-seller
  • Well operator / original seller of the well interests

From the context of structuring an offering, an investor should be able to understand who the key parties are and how they interact. In this case, the relationship between the parties and the disclosures around the relationship was at issue. The same principals allegedly owned and controlled the broker-dealer, the fund (and served on the investment committee of the fund), the fund manager, and the re-seller. The interest re-seller in this case allegedly marked up the well interests to the detriment of direct investors and to investors in the fund. The fund’s PPM did have some disclosure about certain aspects of the conflict of interest, but a key piece of information left out (and the rationale for) was the mark-up of the price from the re-seller to the fund or to investors directly.

Taking a step back, an investor should be able to understand what role each party plays and what role they will play once the investment is made. The model here was not necessarily an issue because it was overly complicated. Sophisticated investment vehicles and structures may involve multiple parties and many moving pieces. To facilitate an investor’s purchase decision, an issuer should be able to explain all those moving pieces in a concise way. Also, the issuer should be clear about the identity and experience, for example, of the fund manager and the operators. Of course, an issuer must disclose conflicts of interests and the main financial details and risks connected to the operation of the investment opportunity.

3. Disclose compensation and fees

After you clearly defining who is doing what, it is important to clearly disclose what each of those parties is getting paid for their role. Again, the issue in the enforcement actions was that because the key players, including the broker-dealer and its principals were all related, the sales may have constituted fraud on the investors.

Even without that present, every dollar that come out of an investor’s pocket is one dollar less to go towards the underlying investment opportunity. Therefore, even though not directly tied to a “project’s” success, an issuer should still consider how fees add to the investor’s ROI.

The structure of having a related fund and fund manager is not foreign. In fact, it’s extremely common, investors can accept it, and these parties have a significant value-add to investors. This is particularly true when the fund managers and operators understand the industry, know how to execute, and can allocate investment decisions to the benefit of investors. A broker-dealer can provide a valuable service as an independent party performing diligence on the offering, the issuer, and the investor.

Sophisticated investors, though, know what that’s worth and will not rubber stamp “asset management fees” and “marketing allowances;” and placement fees and allowances just for the sake of paying additional fees to those trying to profit from the raise itself. Like any purchase, make sure that fees align with not only the market you are in, but with the expertise of those involved, and the value of the product being sold.

4. Think about the investor first

Ultimately, regulators care about protecting the investor. If an issuer and those providing services for a raise strive to do the same, the enterprise and all involved are well on the way to a compliant and efficient capital raise. Think about the investor as the main stakeholder through investment structure, process, and execution. Then, put the money to work in a way to help your investors achieve their return goals. It sounds simplistic, but it works to the benefit of multiple parties, and is often overlooked. 

Understanding when you are selling securities and explaining clearly who is involved with the process and what each party is paid are key tenants of successfully and compliantly securing private capital.


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When a Real Estate Interest is a Security

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meets real estate security. Our e-Book breaks down this vital distinction.



Disclaimer: WealthForge provides this information to our clients and other friends for educational purposes only. It should not be construed or relied upon as legal advice.

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About author

Tim Boykin

Tim focuses on strategic, firm-wide risk management, including cybersecurity and regulatory matters. His goal is to provide excellent customer service, while appropriately limiting liability, for WealthForge’s internal and external clients and stakeholders. Tim earned a bachelor’s degree from the College of William and Mary and received a JD and MBA from the University of Richmond. He holds the CIPP/US certification.
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