Due Diligence Under
Current Regulatory
Standards
Prepared by:
Brandon S. Reif
WINGET SPADAFORA & SCHWARTZBERG LLP
1900 Avenue Of The Stars, Suite 450
Los Angeles, CA 90067
Tel: 310.836.4800
Reif.B@WSSLLP.COM
Obligations of Broker Dealers
Reasonable Basis Suitability:
•
Requires a reasonable basis to believe that the
investment is suitable for some retail customer.
•
The broker dealer must understand the nature of the
recommended security or the investment strategy and
the potential risks and rewards.
See Notice to Member 10-22; 13-31; FINRA rule 2111.
Reasonable Basis Suitability
Steps for Conducting a Due Diligence Investigation:
•
Examine the private placement memorandum (PPM);
•
Review current registration statements and financial
reports;
•
Ascertain the personal history of sponsor’s managers
and owners;
•
Verify any self serving statements by the sponsor or
its managers; and
•
Follow up on any red flags.
See Notice to Member 10-22; 13-31; FINRA rule 2111.
Reasonable Basis Suitability
Be Sensitive to Red Flags and Inquire Further:
•
Financial statements and back-up;
•
Level of cooperation and thoroughness of
disclosures;
•
Presence or lack of clear research and investment
processes;
•
Undisclosed potential conflicts of interest; and
•
Background checks of managers, i.e. regulatory
history, bankruptcy, or valuation concerns.
See SEC, Investment Advisor Due Diligence Processes for
Selecting Alternative Investments and their Managers (Jan. 28,
2014).
Obligations of Broker Dealers
Customer specific suitability means the
investment is suitable for the specific customer
based on his/her:
•
Age;
•
Investment experience;
•
Liquidity needs and risk tolerance;
•
Other holdings;
•
Financial situation and needs;
•
Tax status;
•
Investment time horizon; and
•
Investment objectives.
See FINRA, Notice to Member13-31; FINRA rule 2111.
Customer Specific Suitability
Customer Specific Suitability Applies To
Recommendations Made To Customers.
• Customers are individuals who are not broker dealers and
(1) open a brokerage account with a broker dealer OR (2)
purchase a security for which the broker dealer will receive
compensation.
• Recommendations include (1) suggestions to purchase
securities and (2) explicit advice to hold securities.
See FINRA, Notice to Member 12-55; 13-31; FINRA rule 2111.
Recent FINRA Cases
Madhany v. Citigroup Global Markets
• FINRA arbitrators found that the registered representatives
recommended unapproved securities that were not adequately
investigated.
• FINRA panel awarded claimants $1,047,334.00 in
compensatory damages and up to $10,031,229.25 to
indemnify claimants for third party liability.
See FINRA Award, Madhany v. Citigroup Global Markets, Inc f/k/a Smith
Barney Case No. 10-04929 (Sept. 16, 2013).
Recent FINRA Cases
Gruberman v. LaSalle Street Securities LLC
• FINRA arbitrators found broker dealer liable for breaching their
fiduciary duty based on:
• Failure to complete due diligence before
recommending securities and provide full disclosure
relating to third party findings in due diligence report.
• FINRA panel awarded claimants $135,000.00.
See FINRA Award, Gruberman v. LaSalle Street Securities LLC Case No.
12-02021 (Jan. 30, 2014).
Recent FINRA Enforcement Action
In Re Sunset Financial Services, Inc.
•
Broker dealer failed to investigate the following red flags
resulting in FINRA fines:
•
Sponsor’s financial difficulties;
•
Third party report detailing high default rate;
•
Same management of second offering where first failed;
•
Placement of securities on the approved list of offerings
before due diligence was complete; and
•
Failure to supervise recommendations and due
diligence procedures.
See FINRA Letter of Acceptance, Waiver and Consent No. 2011026915701
In Re Sunset Financial Services, Inc. (July 2, 2013).
Regulatory Priorities for 2014
2014 SEC Regulatory Priorities Include:
•
Assessment of alternative investments;
•
Leverage, liquidity, staffing, funding, and marketing to
investors;
•
Representations and recommendations to investors;
•
Fraudulent sales practices and unsuitable recommendations;
and
•
Firm supervision of private securities transactions.
See SEC, Examination Priorities for 2014 (Jan. 9, 2014).