I am currently in the midst of a FINRA examination that is largely focused on the adequacy of the due diligence that my broker-dealer client conducted of a private placement. What is puzzling about the exam is that FINRA is not just interested in the due diligence that was conducted prior to effecting any sales to customers, but, as well, the due diligence that my client did after the sale, i.e., “ongoing due diligence,” specifically, to determine whether or not the issuer, in fact, utilized the proceeds of the sales in a manner consistent with the description in the private placement memorandum, or PPM. And that got me wondering about so-called “ongoing due diligence,” where that supposed duty arises from, and how it appears to be utterly inconsistent with the notion that broker-dealers’ obligations to their customers are transaction based, essentially ending once a recommendation to buy (or sell, hold or exchange) is made.
Certain things about suitability are easy, and well accepted. As FINRA Rule 2111 makes clear, before an RR can recommend a security to anyone, he first must conduct due diligence, i.e., reasonable basis suitability, to ensure that the product is suitable for some investor, somewhere. If that test is passed, then the RR moves on to customer specific suitability, to determine whether the security is appropriate for a particular customer, based on the customer’s investment objective, risk tolerance, financial wherewithal, time horizon, liquidity needs, etc. Assuming that the security is suitable, and a recommendation is made, that is where the RR’s responsibility to his customer ends. There is no duty to continue to monitor the investment, or the account, or the market. This, in a nutshell, is what distinguishes the role that a BD plays from that of an investment advisor. Because an IA has a fiduciary duty, not a suitability duty, its obligations to its customers continue after the sale, and include the ongoing need to monitor the investment, the account, the market.
So where, then, does FINRA come up with idea that BDs have some duty to conduct “onging due diligence” after a sale is effected? My client has been subjected to intense scrutiny regarding the steps it took, on an ongoing basis, to ensure that the issuer of the private placement applied the proceeds of the offering exactly how the offering materials described they would be applied. What I cannot figure out is why my client supposedly had a duty to undertake this inquiry, once the sales to the customers were made? How is a private placement any different than an ordinary stock, bond, or mutual fund? Once those products are sold, no one, even FINRA, would argue that there is some duty for an RR to track the investment and, in response to what ensues, make further recommendations. Yet, when dealing with private placements, FINRA has apparently created some entirely new duty – one not based on any rule – to conduct ongoing, as opposed to initial, due diligence of the issuer and the security sold. That makes no sense.
Regulatory Notice 10-22 is the gospel when it comes to outlining what reasonable due diligence consists of, at least in FINRA’s eyes, when selling Reg D private placements (although FINRA states in that notice that “many of the [reasonable investigation] practices” described there “are appropriate for other types of offerings”). Interestingly, nowhere in that notice does FINRA discuss, or even mention, ongoing due diligence. The entirety of the notice is devoted to the nature and scope of the due diligence that must be conducted before a recommendation to purchase is made. There is not even a suggestion that, post-sale, a BD should have any concern, or need to have any concern, about what the issuer does with the proceeds. Perhaps it is an issue if a BD promises to conduct ongoing due diligence, but then fails to do so. In a 2011 AWC, Credit Suisse agreed to pay a $350,000 fine for, among other things, acting inconsistently with “marketing materials that stated that the firm had performed or was continuing to perform continuous and ongoing due diligence.” Similarly, in a 2013 Offer of Settlement, Daryl Holzberg, a registered principal responsible for his firm’s compliance pertaining to the sale of private placements, was sanctioned for inadequately implementing the written supervisory procedure that required he “undertake ongoing due diligence and ‘reassess’ the suitability issues concerning the product.”
Those sanctions make some sense, I suppose. But, what if the firm has no WSP requiring that it undertake post-sale, ongoing due diligence, as is likely the case with most BDs? In that circumstance, I simply cannot understand FINRA’s interest in and concern over whether or not my client conducted ongoing due diligence. It is the height of unfairness to subject a firm to some standard that exists nowhere except, perhaps, in FINRA’s imagination.
I have spent six days in OTRs already, with another two scheduled, in large part so FINRA can ask questions about something my client had no obligation to do.
How can this happen?
I feel like Yul Brynner (without the cool costume, or the abs).