7.3 DPP Suitability and Risks

FINRA Rule 2310: Suitability and the Expense Cap

FINRA Rule 2310 sets the standards member firms must meet before selling a DPP. Two ideas dominate the exam.

First, the firm must have reasonable grounds to believe the program is suitable, based on the customer's financial situation, needs, and ability to bear economic risk, and must disclose all material facts (objectives, risks, fees, conflicts, tax features).

Second, Rule 2310 limits organization-and-offering (O&O) expenses — sales commissions, marketing, due-diligence, and formation costs — to no more than 15% of the gross proceeds of the offering. This protects investors by ensuring at least 85% of their money reaches the actual venture. "Use of proceeds" questions hinge on this 15% ceiling: if a program's offering documents show only 70 cents of each dollar going to the investment, fees are excessive and the deal fails the rule.

Rule 2310 also bars a firm from participating in a DPP unless it has conducted reasonable due diligence on the issuer and the GP, and it prohibits a member from being compensated in ways that are not fully disclosed. The same rule limits the broker-dealer's affiliation: a firm cannot recommend a program in which it has an undisclosed conflict. The practical exam takeaway is that DPP suitability is a two-layer test — the program itself must be sound (firm-level due diligence) and appropriate for the specific customer (account-level suitability).

The Suitable DPP Investor

DPPs are appropriate only for a narrow profile.

Not suitable: investors needing liquidity or current income certainty, those in low tax brackets (the deductions are wasted), conservative investors, short-horizon investors, and the unsophisticated. A retiree living on a fixed income who might need the principal back within a few years is the classic wrong customer, even if wealthy, because the money can be locked up for a decade.

Watch how the exam stacks facts. A 40-year-old in the 37% bracket with a $3 million liquid net worth, an existing diversified portfolio, and no near-term cash needs is an ideal candidate. Change one fact — say the customer will need the funds for a home purchase in two years — and the recommendation becomes unsuitable on liquidity grounds alone. Suitability is judged on the customer's full profile, not just net worth.

The Five Core DPP Risks

1. Liquidity risk (MOST significant) — no secondary market; an LP who must exit early may find no buyer or accept a steep discount.
2. Business/economic risk — wells come up dry, properties lose value, equipment becomes obsolete, leases default.
3. Legislative/tax risk — Congress can shrink or repeal the deductions, or the IRS can disallow them; the value proposition can vanish.
4. Management risk — the GP may be inexperienced, conflicted, or charge excessive fees.
5. Leverage risk — borrowed money magnifies both gains and losses and, with recourse debt, personal exposure.

Recourse vs. Non-Recourse Debt

The distinction controls both at-risk basis (how much loss an LP can deduct) and personal liability.

Exam logic: recourse debt is a double-edged sword — it boosts the deductions an LP can claim but also makes the LP personally liable for that share. Non-recourse debt generally does not add to basis, with the important real-estate carve-out.

Liquidation Priority

When the partnership dissolves, claims are paid in this order:

Memory aid: SGLG — Secured creditors, General creditors, Limited partners, General partners. Creditors always precede owners; among owners the GP is last because the GP bears unlimited liability for the partnership's debts.

Within the limited-partner tier, the order is return of capital first, then any profit allocation — an LP recovers their investment before sharing in residual gains. The GP sits last among claimants because the GP carries unlimited liability and is expected to make the partnership's creditors whole; in a failed program, GPs frequently recover nothing.

Apply this to a quick scenario: a partnership liquidates with $1 million after the secured lender is repaid, owing $400,000 to unsecured trade creditors. Those general creditors are paid in full first, leaving $600,000 for the limited partners' return of capital before the GP sees a dollar.

Exam trap: Students reverse "limited partners before general partners." LPs are paid before GPs, but only after every creditor is satisfied.