Due Diligence Doldrums

Whether you are a registered representative, an investment advisory representative, or both, you have a legal obligation to do your due diligence regarding the suitability of any investments you intend to recommend to your clients.  What many brokers and advisory reps do not understand is that the duty to do due diligence is a personal one.  Simply relying on third party reports and ads, wholesaler representations or even compliance officer decisions does not guarantee that a broker or reps will not be held liable if a recommended investment is later determined to be unsuitable.

Back in my compliance days, brokers would constantly get upset with me when I would not approve a trade because I had questions regarding a piece of sales literature provided by a wholesaler or inconsistencies between a fund prospectus and a wholesaler’s representations.  What I knew, and the brokers did not, was that reasonable reliance on third parties is generally not an effective defense against a finding of unsuitability, against a claim of failure to perform the required due diligence.

Two personal cases will always stand out for me.  In one case, a wholesaler for a prominent mutual fund company had been promoting one of the company’s newer funds as a “growth” fund.  The brokers were submitting a stream of purchases for the fund for growth oriented investors.  The branch manager and I had decided to see if the reps were even bothering to actually review the fund’s prospectus, which clearly stated that the fund was for investors looking for aggressive growth.   Every rep stated that they had read the prospectus, but I rejected every trade submitted for the fund as they exceeded the “growth” investment objective of the investor.  

I used the case to warn the brokers of the need to review advertising and other materials provided by third parties.  Most of the brokers realized I was watching out for them and eventually thanked me.

The second incident involved a piece of sales literature that a wholesaler had been secretly distributing to the brokers.  Fortunately, some of the brokers alerted me to the ad and I contacted the fund company to request a copy of the NASD letter approving the piece.  When I recieved the NASD letter, I immediately noticed several issues that the NASD had raised that had not been corrected.  Had the brokers used the uncorrected sales piece, they could have been held liable along with the mutual fund company.

Good compliance officers should perform a lot of this preventive due diligence for brokers.  I always recommend that brokers follow up with compliance and document their files with a copy of the supporting documentation.  If nothing else, it shows that the broker made a  good faith effort at due diligence and did not just blindly accept a thrid party’s representations.

Unfortunately, RIAs are often not as experienced in compliance and fail to properly guard against potential due diligence claims.  The required compliance files are often incomplete or missing and there is rarely any supporting documentation to show that due diligence was performed prior to using any sales literature provided by a wholesaler or other third party.

Bottom line, always perform your own due dilgence regarding potential investment recommendations and document what you did and when you did it.  Before distributing any third party materials, request a copy of the Finra approval letter to ensure that the material was approved as submitted.  If the approval letter was conditioned on changes being made to the submitted material, check to see that the changes were actually made.  Based on my experience, many third parties do not make any changes and just distribute the material since they know few even ever ask to see the approval letter.  If the wholesaler or third party refuses to produce the actual NASD letter, do not use the piece and note this refusal to copperate going forward.

About jwatkins

I am a securities and ERISA attorney. I am a CFP Board Emeritus™ and an Accredited Wealth Management Advisor™. I am a 1977 graduate of Georgia State University and a 1981 graduate of the University of Notre Dame Law School. I am the author of "CommonSense InvestSense: The Power of the Informed Investor" and " The 401(k)/403(b) Investment Manual: What Plan Sponsors and Plan Participants REALLY Need To Know. " As a former compliance director, I have extensive experience in evaluating the legal prudence of various types of investments, including mutual funds and annuities. My goal is to combine my legal and compliance experience in order to help educate investors and investment fiduciaries on sound, proven investment strategies that will help them protect their financial security and/or avoid unnecessary fiduciary liability exposure.
This entry was posted in compliance, investments, retirement plans, RIA, RIA Compliance, securities and tagged , , , , , , , , . Bookmark the permalink.

1 Response to Due Diligence Doldrums

  1. harvey friedentag says:

    Your comments are right on. I always do what you have pointed out. There are so many trying to fool people.
    I attend many senior presentations and I always ask questions starting with what are your credentials. Many are not licenced and give erroneous information just to sell their wares.

Comments are closed.