Evaluation of DPPs
Before recommending a Direct Participation Program (DPP) to a client, a registered representative must perform thorough due diligence under FINRA Rule 2310. This section covers the evaluation framework and compensation limits that the exam frequently tests.
Due Diligence Factors (FINRA Rule 2310)
FINRA Rule 2310 requires members to perform reasonable due diligence before recommending a DPP. The key factors to evaluate:
| Factor | What to Evaluate |
|---|---|
| Economic soundness | Is the program viable independent of tax benefits? Would an investor participate without any tax advantage? |
| General partner (GP) expertise | Track record, experience, financial stability of the GP/sponsor |
| Program objectives | Stated goals (income, appreciation, tax shelter) match investor needs |
| Start-up costs | Front-end load: what percentage of invested capital goes to fees vs. productive investment? |
| Leverage | Degree of borrowing; higher leverage increases risk and potential return |
| Revenue considerations | Revenue projections, market conditions, competitive landscape |
The Economic Soundness Test
This is the single most important evaluation criterion:
- A DPP must be economically sound: it must make financial sense even without tax benefits
- Tax benefits alone are not a valid reason to invest
- If a program only makes sense because of the tax write-offs, it fails the economic soundness test
- Members must ensure the investor has the financial ability to sustain the risks, including illiquidity and potential total loss
Think of it this way: If someone pitched you a business deal that would lose money but "the tax write-offs are great," you would be suspicious. The same logic applies here. A DPP must be a good investment on its own merits. Tax benefits are a bonus, never the reason.
Exam Tip: Gotchas
The economic soundness test is the most important DPP evaluation criterion and a frequent exam topic. A question might describe a program that offers large deductions but has questionable economics. The correct answer is that the program should NOT be recommended regardless of the tax benefits.
Compensation and Expense Limits (FINRA Rule 2310)
FINRA sets strict limits on what can be charged:
| Limit | Maximum |
|---|---|
| Organization and offering expenses | Presumed unfair if they exceed 15% of gross proceeds (when a member-affiliate is the sponsor) |
| Total underwriting compensation | Cannot exceed 10% of gross offering proceeds |
Additional Compensation Rules
- Non-cash compensation is restricted to:
- Gifts not exceeding $300 per year per person
- Occasional meals and entertainment
- Training and education meetings
- Compensation paid before escrow release is prohibited
- All forms of compensation from any source count toward the 10% cap, including sales commissions, wholesaling fees, due diligence expenses, finder's fees, and consulting fees
Exam Tip: Gotchas
- Organization and offering expenses cap is 15% (member-affiliate sponsor), but total underwriting compensation cap is 10%. These two limits are frequently tested together.
- Non-cash compensation is limited to $300/year per person. Occasional meals and training meetings are allowed but do not count toward this cap.
- Compensation before escrow release is prohibited. If the exam describes a broker-dealer (BD) receiving fees before the offering is fully funded, that arrangement violates FINRA rules.
Limited Partnership Rollups
A rollup combines multiple existing limited partnerships into a single entity (often a corporation or REIT):
| Rollup Rule | Requirement |
|---|---|
| Solicitation compensation | Cannot exceed 2% of the exchange value of newly created securities |
| Compensation must be equal | Same amount regardless of whether the partner votes for or against the rollup |
| Dissenting partners | Must be offered fair value, typically based on independent appraisal |
| Approval threshold | Typically requires 75% limited partner vote with independent committee oversight |
Dissenting Partner Protections
Dissenting limited partners must be offered one of:
- Compensation based on an independent appraisal of partnership assets
- The right to retain a security with substantially the same terms as the original
- Other comparable rights
Exam Tip: Gotchas
- Rollup solicitation compensation is capped at 2% of exchange value. This is much lower than the 10% underwriting compensation cap for new DPP offerings.
- Compensation must be equal regardless of how the partner votes. A broker cannot receive more for delivering "yes" votes on a rollup.