Quick Answer
FINRA's DPP due-diligence rule requires reasonable due diligence before recommending a DPP, centered on the economic soundness test: the program must make sense even without its tax benefits. The rule also caps underwriting compensation at 10% of gross proceeds, presumes offering expenses over 15% unfair, and limits rollup solicitation pay to 2% of exchange value.
Before recommending a Direct Participation Program (DPP) to a client, a registered representative must perform thorough due diligence under FINRA's DPP rule. This section covers the evaluation framework and compensation limits for recommending a DPP.
What Factors Must Be Evaluated Before Recommending a DPP?
The DPP due-diligence rule 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.
What Must the Member Document and Disclose Before Recommending a DPP?
For every recommendation, the member must have reasonable grounds, based on the participant's objectives, other investments, financial situation and needs, and other known information, to believe that:
- the investor can meaningfully realize the program's stated benefits;
- the investor has sufficient fair-market net worth to bear the risk and illiquidity; and
- the program is otherwise suitable.
The member must retain the basis for that determination in its files. A discretionary DPP transaction additionally requires the customer's prior written approval. Before executing a purchase of a DPP or REIT, the member must also inform the prospective investor of material facts about liquidity and marketability, including whether the sponsor's prior programs or REITs liquidated around previously disclosed target dates.
Exam Tip: Gotchas
A sponsor's history of missing its own disclosed liquidation target dates is a required disclosure, not just useful color. If the exam describes a member that recommends a DPP without mentioning the sponsor's prior programs' liquidation track record, that member has skipped a required suitability disclosure.
What Are the Compensation and Expense Limits?
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 easily confused.
- 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.
What Rules Apply to 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 |
Comparable Dissenting-Partner Protections
Two listed ways to satisfy the comparable-protection standard for dissenting partners:
- 75% approval: approval by 75% of the outstanding units of each participating partnership, with any partnership that misses that threshold excluded from the rollup; or
- Independent committee: a committee approved by a majority of each partnership's outstanding securities, whose deliberations normally may not exceed 60 days unless extended unanimously or by FINRA
Dissenting limited partners must also 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
A separate exemption applies when a non-affiliated party succeeds to the general partner's interests: it requires approval by at least 66 2/3% of the outstanding units of each participating partnership and limits the existing general partners to compensation expressly provided in the pre-existing partnership agreements. This is not the general rollup-approval threshold.
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.
- Don't confuse the 75%/independent-committee dissenting-partner protections with the 66 2/3% threshold. The 66 2/3% figure applies only to the distinct exemption for a non-affiliated party succeeding to the general partner's interests.
What Should You Check on Exam Day?
- Economic soundness is the central due-diligence test: a DPP must make sense without its tax benefits.
- The member must document reasonable grounds for suitability, retain that basis in its files, and get prior written approval for discretionary DPP transactions.
- Before a DPP or REIT purchase, the member must disclose material liquidity and marketability facts, including whether the sponsor's prior programs liquidated around disclosed target dates.
- Organization and offering expenses are presumed unfair above 15% of gross proceeds (member-affiliate sponsor); total underwriting compensation is capped at 10%.
- Non-cash compensation is limited to $300 per person per year in gifts, plus occasional meals and training; compensation before escrow release is prohibited.
- Rollup solicitation compensation is capped at 2% of exchange value; the 66 2/3% approval threshold applies only to the non-affiliated GP-succession exemption, not general rollup approval.