A number of lawsuits, some in the form of class actions, have recently been brought against broker-dealers ("BD's") for allegedly failing to properly conduct due diligence on private placement securities. When a firm loses one of these cases, damages can be substantial and in some instances enough to bring down the entire firm.
Perhaps it is time to review BD due diligence obligations and specifically FINRA's (the acronymn stands for the Financial Industry Regulatory Authority) view of the same. In Regulatory Notice 10-22 FINRA reminded BD's of their obligation to conduct a reasonable investigation of the issuer and securities they recommend in private placement (Regulation D) offerings.
The Notice cited instances of BD fraud and sales practice abuse such as provision of private placement memoranda and sales materials to investors that contained inaccurate statements or omitted material information needed for investors to make informed investment decisions.
Noting that failure to conduct reasonable due diligence could be a violation of anti-fraud provisions of the securities laws[1] as well as FINRA rules[2], the Notice referred to the courts having found that the amount and nature of the investigation required depended, on among other factors, the role of the BD in the transaction, its knowledge of and relationship to the issuer, (a BD affiliated with an issuer has to ensure that its affiliation does not compromise its independence in its investigation) and the size and stability of the issuer. For example, a newer, smaller issuer, which would include many issuers in private placements , would require a more thorough investigation.
Also, the Notice pointed out that the presence of “red flags” [3] in an offering should alert a BD to conduct further inquiry. Interestingly enough, although acknowledging that private placement memoranda were not required for private placements to “accredited investors” in Rule 505 or 506 offerings under Regulation D, the Notice questioned, in view of the fact that such private placement memoranda were commonly used in Regulation D offerings, whether the absence of such a memorandum might be a red flag.
Many BD retain counsel or outside experts to assist the firm in due diligence. However, the Notice makes it dear that a BD needs to carefully screen the qualifications and competence of such persons, ensure that all gaps or omissions in such third party investigation are addressed by the BD, and that the BD itself is responsible to conduct such further investigation as a review of the counsel’s or expert’s report might indicate.
A BD which is only a member of a selling group or a syndicate may rely upon the due diligence of the syndicate manager if the BD has reason to believe that the syndicate manager has the needed expertise and absence of conflicts to conduct a proper investigation, and that in fact the syndicate manager did perform such inquiry. The BD should meet with the manager, obtain a description of the due diligence activities of the manager, and ask questions of the manager with regard to the manager’s independence and the thoroughness of the manager’s investigation. Also the BD maintains responsibility to conduct its own due diligence on issues not covered by the manager.
The Notice also reminded broker-dealers that securities offered in private placements had to meet the suitability requirements of NASD Rule 2310 and comply with FINRA and SEC advertising and suitability rules. Moreover, the Notice detailed the records a BD should keep to document that it undertook a reasonable investigation.
While noting that no single checklist would suffice for every due diligence investigation, the Notice did give the following list of practices that some firms have used to help them in carrying out their due diligence responsibilities:
A. Issuer and Management
Reasonable investigations of the issuer and its management concerning the issuer’s history and management’s background and qualifications to conduct the business might include:
Examining the issuer’s governing documents, including any charter, bylaws and partnership agreement, noting particularly the amount of its authorized stock and any restriction on its activities. If the issuer is a corporation, a BD might determine whether it has perpetual existence.
Examining historical financial statements of the issuer and its affiliates, with particular focus, if available, on financial statements that have been audited by an independent certified public accountant and auditor letters to management.
Looking for any trends indicated by the financial statements.
Inquiring about the business of affiliates of the issuer and the extent to which any cash needs or other expectations for the affiliate might affect the business prospects of the issuer.
Inquiring about internal audit controls of the issuer.
Contacting customers and suppliers regarding their dealing with the issuer.
Reviewing the issuer’s contracts, leases, mortgages, financing arrangements, contractual arrangements between the issuer and its management, employment agreements and stock option plans.
Inquiring about past securities offerings by the issuer and the degree of their success while keeping in mind that simply because a certain product or sponsor historically met obligations to investors, there are no guarantees that it will continue to do so, particularly if the issuer has been dependent on continuously raising new capital. This inquiry could be especially important for any blind pool or blank-check offering.
Inquiring about pending litigation of the issuer or its affiliates.
Inquiring about previous or potential regulatory or disciplinary problems of the issuer. A BD might make a credit check of the issuer.
Making reasonable inquiries concerning the issuer’s management. A BD might inquire about such issues as the expertise of management for the issuer’s business and the extent to which management has changed or is expected to change. For example, a BD might inquire about any regulatory or disciplinary history on the part of management and any loans or other transactions between the issuer or its affiliates and members of management that might be inappropriate or might otherwise affect the issuer’s business.
Inquiring about the forms and amount of management compensation, who determines the compensation and the extent to which the forms of compensation could present serious conflicts of interest. A BD might make similar inquiries concerning the qualifications and integrity of any board of directors or similar body of the issuer.
Inquiring about the length of time that the issuer has been in business and whether the focus of its business is expected to change.
B. Issuer’s Business Prospects
Reasonable investigations of the issuer’s business prospects, and the relationship of those prospects to the proposed price of the securities being offered, might include:
Inquiring about the viability of any patent or other intellectual property rights held by the issuer.
Inquiring about the industry in which the issuer conducts its business, the prospects for that industry, any existing or potential regulatory restrictions on that business and the competitive position of the issuer.
Requesting any business plan, business model or other description of the business intentions of the issuer and its management and their expectations for the business, and analyzing management’s assumptions upon which any business forecast is based. A BD might test models with information from representative assets to validate projected returns, break-even points and similar information provided to investors.
Requesting financial models used to generate projections or targeted returns.
Maintaining in the BD’s files a summary of the analysis that was performed on financial models provided by the issuer that detail the results of any stress tests performed on the issuer’s assumptions and projections.
C. Issuer’s Assets
Reasonable investigations of the quality of the assets and facilities of the issuer might include:
Visiting and inspecting a sample of the issuer’s assets and facilities to determine whether the value of assets reflected in the financial statements is reasonable and that management’s assertions concerning the condition of the issuer’s physical plants and the adequacy of its equipment are accurate.
Carefully examining any geological, land use, engineering or other reports by third-party experts that may raise red flags.
Obtaining, with respect to energy development and exploration programs, expert opinions from engineers, geologists and others are necessary as a basis for determining the suitability of the investment prior to recommending the security to investors.
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Robert Kiggins, Esq. of McCarthy Fingar LLP, is author of the blog, and may be reached at (914) 385-1024 or rkiggins@mccarthyfingar.com.
Nothing is this blog is intended to be or may be relied upon as specific legal advice. Securities and related laws are complex and facts are different from case to case. Competent counsel should be consulted. Views expressed by the author in this article are his own and not those of any other person.
[1] E.g. Section 17(a) of the Securities Act, Section 10(b) of the Securities Exchange Act and Rule 10b-5 thereof.
[2] See FINRA Rule 2010 and FINRA Rule 2020.
[3] The Notice cited a federal case where the court held that the duty to investigate is greater “where promotional materials are in some way questionable, for example by promising unusually high returns”; the Notice citing another federal case also referred to inability to rely on audited financial statements where there were “red flags” that indicated the financial statements were inaccurate; also an issuer's refusal to provide information was cited as another red flag
