Due Diligence and Registered Representatives

The topic of due diligence is widely discussed regarding the financial services industry.  Due diligence of products.  Due diligence of potential employees.  Due diligence of client suitability.  But, what exactly does it mean when applied to financial services and what does it mean to representatives?

“Due diligence” is commonly defined as an investigation of a business or person prior to signing a contract, or an act with a certain standard of care.  Due diligence, in the financial services world, is commonly seen as the process of investigation and evaluation, into the details of a potential investment, such as an examination of operations and management and the verification of material facts.

The term “due diligence” first came into common use as a result of the Securities Act of 1933. The Act included a defense noted in Section 11, referred to as the “Due Diligence” defense, which could be used by firms when accused of inadequate disclosure to investors of material information with respect to the purchase of securities.

From there, the topic and what it implies have grown tremendously.  Due diligence is no longer used as a defense, but is a requirement to be conducted and so done with great detail and attentiveness.

We all know that firms have a requirement to conduct due diligence on products and services that they offer to their clients.  A broker-dealer must conduct a due diligence review prior to participating in a private placement offering.  A registered investment advisor must conduct due diligence on potential sub-advisors that it may use.  But what level of diligence must a representative conduct? May he simply rely upon his firm and the due diligence it conducted?

This question is a hard one to answer with any certainty.

When conducting due diligence investigations, very often someone ends up relying or trusting the words or reports of others.   There is no doubt that a representative “should” be able to rely on his firm’s reviews, at least to some degree. That being said, a representative is simply not left off the hook with respect to due diligence.

The standards of the securities industry do not require representatives to perform a duplicative review on the products or services offered by and through his firm.  What is required is that the representative be reasonable at taking at face value the recommendations of his firm.

Each of a registered representative and an investment advisory representative has a duty to their clients that must be followed through upon.  A registered representative must “know his customer” and only recommend “suitable” investments.  An investment advisory representative has an even greater threshold and has a “fiduciary duty” to act in his clients’ best interests.

In either case, you must have a firm understanding of both the investment product or service and the client. The lack of such an understanding clearly violates both the suitability rule and fiduciary obligation.  You must know all aspects of the client, know all the aspects of the investment and then must apply your knowledge of both to determine if it is appropriate for the client.  In either capacity, it is required that due diligence be performed on each of the investments and strategies to be utilized.

So, now we know that there is a level of due diligence required by representatives, but what should you, as a representative do?

Red flags are exactly what the due diligence process is supposed to discover.  A red flag is a warning sign, a concern, an unknown risk, a conflict of interest, an alarming fact, an unanswered question or just something that doesn’t quite add up.  If there are a number of red flags discovered before any true due diligence review has been conducted, why would an investor even consider making the investment?  Not conducting proper due diligence is not only against securities regulations; it is against the best interest of your client.

You have an obligation to follow-up on red flags that are discovered. Research further into the issues.  Escalate them to your compliance department.  Discuss them with your firm’s investment committee.  Just don’t disregard them entirely and act as though everything is “squeaky clean.”  Ignoring red flags can lead to regulatory issues or litigation for both you and your firm and potentially catastrophic losses for your clients.

One of the most crucial aspects of a due diligence review is to have a firm grasp and understanding of the investment.  As indicated previously, you have an obligation to understand the investment to be recommended to your clients or utilized in their advisory account.  To truly understand the investment, you must educate yourself on its risks, strategies and potential conflicts.  Further, you should ensure that you take part in training on the investment.  It is common for investment sponsors or fund companies to have training sessions on their investments and the strategies that they may deploy.  In addition, your firms should also conduct internal training on the investments.

One final aspect to account for is the importance of following your firm’s protocol for due diligence reviews.  You should always adhere to your firm’s protocol and escalate any issues, red flags or questions accordingly.  You will be helping to protect not only yourself and your firm, but your clients and their interests, as well.

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