Importance of Brokerage Firm Due Diligence on Alternative Investments
“Alternative investments” generally refer to all non-traditional investments – like stocks, bonds, and mutual funds. Examples include oil and gas limited partnerships, non-traded REITs, business development companies, tenant-in-commons, and equipment leasing funds. The commonality is that alternative investments are high-risk, generally illiquid, and pays a high commission to the advisor that recommends them.
Due to these increased risks, investment regulators like FINRA impose high due diligence requirements on broker-dealers and advisors in an attempt to ensure that alternative investments are not being sold improperly.
In fact, brokerage firms and financial advisors have a fiduciary duty to their clients to perform adequate due diligence on any investment prior to offering it for sale to its clients.
FINRA, for examples, has issued guidance to broker-dealers reminding them of their due diligence obligations specifically as they relate to Regulation D filings for alternative investments.
NTM 10-22, pertinently, includes the following statements:
FINRA has found significant problems in several examinations and investigations. These problems include fraud and sales practice abuses in Regulation D offerings. Recently, for example, broker-dealers were sanctioned for providing private placement memoranda and sales materials to investors that contained inaccurate statements or omitted information necessary to make informed investment decisions.
The [SEC] and federal courts have long held that a BD that recommends a security is under a duty to conduct a reasonable investigation concerning that security and the issuer’s representations about it. This duty emanates from the BD’s “special relationship” to the customer, and from the fact that in recommending the security, the BD represents to the customer “that a reasonable investigation has been made and that [its]recommendation rests on the conclusions based on such investigation.”
…the SEC and courts recognize that a more thorough investigation is required for “securities issued by smaller companies of recent origin,” which could include many Regulation D issuers.
… a BD “may not rely blindly upon the issuer for information concerning a company”…
… nor may it rely on the information provided by the issuer and its counsel in lieu of conducting its own reasonable investigation.
… firms are required to exercise a “high degree of care” in investigating and independently verifying an issuer’s representations and claims.
Indeed, when an issuer seeks to finance a new speculative venture, BDs “must be particularly careful in verifying the issuer’s obviously self-serving statements.”
To demonstrate that it has performed a reasonable investigation, a BD should retain records documenting both the process and results of its investigation. Such records may include descriptions of the meetings that were conducted in the course of the investigation, including meetings with the issuer or other parties, the tasks performed, the documents and other information reviewed, the results of such reviews, the date such events occurred, and the individuals who attended the meetings or conducted the reviews.
These requirements are important to protect the investment public.
Unfortunately, these requirements are often overlooked by brokerage firms and advisors that are more interested in the high commissions they can earn selling such investments than they are in protecting the interests of their clients.
The White Law Group has represented hundreds of investors that have lost money in alternative investments.
These claims generally argue that the brokerage firm is negligent and violated its fiduciary duty by recommending the alternative investment(s) to someone who lacked the sophistication or experience to understand the risks and that the brokerage firm failed to perform adequate due diligence to ensure that the investment had a reasonable likelihood of success.
ABOUT THE AUTHOR: Daxton White
D. Daxton White is the managing partner at The White Law Group, LLC and a member of the Florida and Illinois Bar Associations, as well as the Indian River County Bar Association. He is also a member of the Public Investors Arbitration Bar Association (PIABA).
Mr. White has handled over 600 FINRA arbitration cases, including handling claims against most of the FINRA registered broker-dealers. These cases have included claims for, among other things, unsuitability, fraud, negligence, failure to supervise, and breach of fiduciary duty.
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Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer. For specific technical or legal advice on the information provided and related topics, please contact the author.