Investment Product Due Diligence

Brokerage firms are responsible for conducting due diligence on all securities recommended by the firm or the broker. The due diligence rule is heightened where the investment recommendation is a private placement offering or other type of non-public offering where the brokerage firm is acting as the underwriter or distributor of the securities.

The due diligence rule stems from FINRA Rule 2111 that states that a brokerage firm must have reasonable grounds to believe that a recommendation to purchase, sell, or exchange a security is suitable for the customer. In the context of a Regulation D offering, Notice to Members 10-22: Regulation D Offerings states that a critical part of determining suitability is the obligation to conduct a reasonable investigation of the issuer and the securities they recommend in the private placement offerings. That is, brokerage firms are required to exercise a high degree of care in investigating and independently verifying an issuer’s representations and claims.

FINRA has stated that a brokerage firm has a “special relationship” with a customer from the fact that in recommending the security, the brokerage firm represents to the customer that a reasonable investigation has been made. FINRA has defined the following parameters as the bare minimum a brokerage firm must document in conducting a reasonable investigation for a Regulation D offering and any subsequent offering for the same issuer:

• the issuer and its management;
• the business prospects of the issuer;
• the assets held by or to be acquired by the issuer;
• the claims being made;
• the intended use of proceeds of the offering;
• whether the investor’s money is likely to be applied according to the stated use of proceeds; and
• whether the stated use of proceeds is reasonable in light of the issuer’s business purpose and prospects

The failure of the brokerage firm or broker to investigate and conduct proper due diligence on the claims of the issuer may constitute a failure to supervise the securities offering. It takes an experienced attorney to investigate and uncover a brokerage firm’s failure to conduct proper due diligence.

FINRA, though extensive studies, has determined that broker-dealers that actually conducted reasonable and adequate due diligence in the sale of alternative investment or private placements, conducted independent research on most if not all aspects of the offering it chose to sell to its clients. In addition, FINRA found that firms conducted reasonable due diligence when the firm identified, thoroughly and in writing, red flags with the issuer of the product and can show that the broker-dealer took those flags into consideration before recommending the product. Most importantly FINRA found that all concerns identified by the firm we adequately disclosed to the client investor.

A broker-dealer’s size will be taken into account when determining the level of due diligence a firm must conduct. However, while larger firms must have due diligence committees, smaller firms must designate at least one qualified individual (if not more) to conduct satisfactory diligence described above. For firms of any size, the broker-dealer must conduct independent due diligence and conduct it in such a way that it is not reliant on unverified information issuer. In most cases, a firm’s failure to higher due diligence expert, attorneys, accountants or some qualified third-party vendor, will make the diligence unreasonable and expose the firm to liability.

Similarly, registered investment advisory firms, or RIAs, have similar obligations to conduct proper and adequate diligence in the sale of securities to their clients. Registered investment advisors are registered with the Securities and Exchange Commission (“SEC”) and as such are charged with a fiduciary duty under the Investment Advisor Act of 1940 (“IAA”) to conduct due diligence and disclose all known material facts concerning its investment recommendations.

Our attorneys have the experience necessary to determine whether a broker-dealer or RIA failed to conduct due diligence into a private placement or alternative investment. If you believe you have been a victim of securities misconduct, contact the lawyers at Gana Weinstein LLP.