According to the latest statistics from FINRA, there are currently over 3,000 registered broker-dealers and 634,000 registered representatives on its roles. (See https://www.finra.org/newsroom/statistics) As the EB-5 industry matures, the use of broker-dealers and their registrants are likely to become a greater part of the overall marketing of investment products and a robust channel to access investors.
Marketing to FINRA registrants, however, takes place in an arena of significant regulation. Of primary importance is the broker-dealer’s tacit approval of products and the activities of its registrants. Registrants who seek to skirt the rules and market unapproved products to investors face fatal consequences. The recent case of Jim Seol is an example.
In 1997, Jim Seol (Seol) became a registered representative of Ameriprise Financial, a broker-dealer. According to a complaint filed by FINRA, in 2009 Mr. Seol incorporated Western Regional Center (WRCI), certifying that he was the company’s CEO, CFO, sole director and President. Acting through WRCI, Mr. Seol secured $100 million of EB-5 investments which were released in several tranches to a solar power plant development project in Riverside, California and as a general partner of WRCI, a limited partnership, WRCI received management fees, as is common in EB-5 offerings.
What Mr. Seol neglected to do was to inform his broker-dealer of his outside business activities, and for that reason Mr. Seol is now barred from participating in any securities activities.
So whats the big deal?
FINRA Rule 3270 states “No registered person may be an employee, independent contractor, sole proprietor, officer, director or partner of another person, or be compensated, or have the reasonable expectation of compensation, from any other person as a result of any business activity outside the scope of the relationship with his or her member firm, unless he or she has provided prior written notice to the member …”
The purpose of the Rule is to ensure ‘that firms receive prompt notification of all outside business activities of their associated persons so that the broker-dealer’s objections, if any, to such activities could be raised at a meaningful time and so that appropriate supervision could be exercised as necessary under the law.’”
A registered representative must “disclose outside business activities at the time when steps are taken to commence a business activity unrelated to his relationship with his firm.”
The sweep of Rule 3270 is intentionally broad, requiring registered persons “to report any kind of business activity engaged in, away from their firms, and not only business activities related to securities.”
The practical reasons for this rule are found in legal concepts of agency, as the registered representative of a broker-dealer acts as its agent in all things investment related, whether or not they are approved by a broker-dealer. This concept is further buttressed by what is called the “Shingle Rule,” which in securities law entails that a representative inherently places the “shingle” of their broker-dealer on the purchase or sale of any investment product, regardless of whether it is approved or not.
Broker-dealers take painstaking care to make sure that their registrants are not, as in the case of Seol, “selling away” from them. These measures include regular office inspections, marketing material reviews, audits of cash flows from client accounts and regular attestations from the registrant.
Seol, if he was making efforts to comply with FINRA Rule 3270, would have first notified Ameriprise of his intent to market EB-5 products and operate an entity to collect fees and commissions from the sales of such products. Ameriprise would have had to have undertaken due diligence on the EB-5 products that Seol was selling, as well as provide enhanced supervision of his marketing activities and other procedures intended to protect investors from fraud or the misuse of funds.
Included in such procedures would have been some analysis of the commissions and fees that Seol was receiving in connection with his EB-5 business, and whether such commissions and fees were reasonable. As is often the case in “selling away” matters such as this one, the risks, rewards and conflicts of a business that a registrant knows will not be approved by a broker-dealer often results in uncanny efforts to conceal the activity. It is not the truth that hurts you, but rather the lie.
So what are the takeaways from the Seol case for EB-5 stakeholders?
- EB-5 participants must confirm capacity and approval of their products. Registrants of broker-dealers must have approval from their firms to market EB-5 products. As reflected on Form BD utilized by FINRA, broker-dealers must specifically note that EB-5 products are among the investment vehicles they are able to sell. Anyone dealing with a broker-dealer or a registrant of a broker-dealer must confirm that these things are in place or will be. The broker-dealer will likely request a “placement agreement” or “distribution agreement” with the issuer outlining their respective obligations and liabilities.
- EB-5 investments are subject to due diligence by the broker-dealer. Even if the broker-dealer and the registrant are agreeable to the sale of EB-5 products, FINRA members are required to perform their own due diligence on the actual investments to be sold. FINRA has offered guidance not only in the EB-5 space (see Interpretive Letter to Brian Sweeney, Trustmont Financial Group, Inc., August 26, 2013), but also in the context of private placements and direct real estate investments. See, e.g., FINRA Regulatory Notices 10-22, 12-40 and 16-08. Of primary importance here is the reasonableness of fees and commissions in light of the investment offered.
- Marketing materials for EB-5 investments must be approved by the broker-dealer. Once due diligence is performed to the satisfaction of the broker-dealer, the broker-dealer must also supervise and review sales materials for accuracy, whether provided by the issuer or prepared directly by a registrant. The registrant is obligated to provide these materials to the broker-dealer for review prior to use.
So while broker-dealers and their registrants provide a potentially robust channel to market EB-5 investments, care must be taken to confirm that the regulatory requirements to which they are subject are complied with to the letter.
Robert Cornish, Partner at Wilson Elser Moskowitz Edelman & Dicker LLP, contributed to to this article.