Exploration of Due Diligence Duties
Attorneys: Edward Zusman and David Wakukawa
The adequacy of broker-dealers’ due diligence investigations of products approved for distribution often arises in civil and regulatory actions. Yet there is no civil statute or regulation that provides the basis for a civil action grounded in failure to perform adequate due diligence. The term “due diligence” appears in the Securities Act of 1933 and Securities Exchange Act of 1934 only as a defense available to underwriters participating in a registered securities offering. Recent authority has in fact clarified that an investor cannot advance an independent claim for his or her broker’s alleged negligent due diligence, and there is no legal duty for a broker-dealer to independently verify every representation contained in an offering document. Nonetheless, performing adequate due diligence is necessary for various reasons as discussed herein.
1. Private Cause of Action: No Tort of Negligent Due Diligence Exists
The Southern District of New York, a leading federal district in the area of securities law, recently issued a well-reasoned opinion clarifying that there is no tort of negligent due diligence. It has long been the rule that there is no private cause of action for violations of FINRA and other industry rules, and this opinion confirms the rule in the due diligence context. In BNP Paribas Mortgage Corp. v. Bank of America, 866 F. Supp. 2d 257 (S.D.N.Y. 2012), Judge Sweet considered whether exclusive dealers of notes, who were responsible for the promotion and marketing of the notes, could be held liable for losses when those notes turned out to be part of a fraudulent scheme. The court’s inquiry began with the question of whether the dealers had a duty to verify statements contained in the private placement memoranda (“PPMs”). It was assumed (for the purposes of the motion before the court) that the dealers had actual knowledge of facts indicating a pattern of the issuer’s manipulation and misrepresentation of assets.
The BNP Paribas court noted that private placements do not come within the scope of Section 12(2) of the Securities Act, which creates liability for negligent participation in the creation of offering documents, and that an intermediary dealer’s possible liability could only arise from Rule 10b-5, which requires a demonstration of fraudulent intent. This is a key distinction for the purposes of a broker-dealer’s duty of due diligence. In analyzing a number of other decisions discussing a broker-dealer’s due diligence duties, the court found that those cases do not support a finding of liability based on a dealer’s negligent due diligence. Rather, due diligence arises—not as a predicate to liability—but as a defense to disciplinary charges or allegations of fraud under 10b-5. 866 F. Supp. 2d at 266-67; see also In re Enron Corp. Securities Litig. (S.D. Tex. 2011) 761 F. Supp. 2d 504, 572 (“There is no statutory requirement that an underwriter conduct a due diligence investigation into a proposed public or private offering. The term ‘due diligence’ does not occur in any federal securities statute.”). Consistent with earlier decisions from other federal courts which have considered whether there are causes of action for alleged negligent violations of securities regulatory rules, BNP Paribas held that there is no duty on the part of a broker-dealer to verify the contents of PPMs. 866 F. Supp. 2d at 266-67. (“[E]ach court that has considered the question has concluded that mere negligent violations of the NYSE or NASD rules are not actionable in federal court; rather, to form the basis for liability in damages, the broker’s violations of the rules must be ‘tantamount to fraud.’”) (quoting Rolf v. Blyth Eastman Dillon & Co., 424 F. Supp. 1021, 1041 (S.D.N.Y. 1977)). At least one other federal court also reached the conclusion that there is no general duty to ensure the accuracy of investment materials. Brown v. J.P. Turner, 2011 WL 1882522 (N.D. Ga. 2011) (rejecting the “implied representation” theory). There are cases that appear to impose on brokers an affirmative duty to conduct due diligence and verify an offeror’s statements. But the BNP Paribas court found those cases distinguishable because they involved disciplinary actions, not civil liability, and because their facts point to involvement beyond ordinary broker services, Everest Securities, Inc. v. SEC, 116 F.3d 1235 (8th Cir. 1997), or completely unfounded and overoptimistic selling tactics. Hanly v. SEC, 415 F.2d 589 (2d Cir. 1969).
A more recent decision has affirmed this holding, specifically in the context of the sale of a private placement note offering sponsored by DBSI. Smith v. Questar Capital Corp., 2013 WL 3990319 (D. Minn. 2013). In Questar, the plaintiffs argued that a DBSI selling agent should have conducted its own independent due diligence of the offering before offering it for sale. Citing BNP Paribas, the court rejected the argument that FINRA guidance on due diligence, including Notices to Members 03-71 and 10-22 (discussed below), supported a tort of negligent due diligence because “no duty of due diligence exists between a broker-dealer and a purchaser of securities.” 2013 WL 3990319 at 12. Although the Questar court did not make this point expressly, the regulatory duty of due diligence is completely independent of any duties owed to a client. In fact, according to the plain terms of regulator guidance on the subject, the due diligence obligation arises even before a potential customer exists, and even if the approved investment is never actually purchased through the firm. Furthermore, Questar engaged in a preemption-like analysis for further support of its conclusion, finding that in the securities arena, a “heavily regulated area of the law, the Court finds no basis to create a new common law duty.” 2013 WL 3990319 at 12. So, contrary to the attempts of various plaintiffs to morph FINRA regulations into a previously unrecognized tort, the fact that this area is subject to extensive regulation is instead a factor militating against the fabrication of a new cause of action.
2. Regulatory Obligation: Due Diligence Under FINRA Regulations
BNP Paribas is a proper and much-needed response to ongoing confusion caused by efforts to shoehorn into FINRA’s suitability rules a new tort of negligent due diligence. But despite this holding, it is important to remember that FINRA rules continue to impose on broker-dealers certain duties to investigate issuer representations (despite the fact that those duties should not give rise to private rights of action).
Independent investigation of statements by a securities issuer is of particular importance in the context of Regulation D private placement offerings. The amount and nature of the required investigation will depend on the nature of the security, the size of the broker’s role, the broker’s knowledge of and relationship to the issuer, and the issuer’s size and stability. FINRA Notice to Members (“NTM”) 10-22 at 3. With respect to reporting companies, a broker-dealer who is not an underwriter typically may rely on the current registration statement and reports of a public company in the absence of red flags. NTM 10-22 at 4. But smaller companies of recent origin, or issuers seeking to finance speculative new ventures, may require broker dealer verification of obviously self-serving statements. NTM at 3-4. At a minimum, a firm’s reasonable investigation into a Regulation D offering should cover the issuer and its management, its business prospects, its current or future assets, the claims being made, and the intended use of the offering proceeds. NTM 10-22 at 5. FINRA has offered additional guidance on these aspects of a firm’s due diligence through non-exhaustive checklists of issues to examine. NTM 10-22.
Specifically regarding tenant-in-common (“TIC”) investments, FINRA has issued additional guidance stating that a broker’s due diligence should include verifications of facts in offering documents. NTM 05-18 at 4. For TIC investments, FINRA has taken the position that reasonable investigation to ensure that offering documents do not contain false or misleading information could include background checks on the sponsor’s principals, review of property management and financing agreements, and property inspection. Id. Furthermore, when an offering document contains projections, members should understand both the basis of those projections and the likelihood of their occurrence. Id.
Although FINRA’s suitability rules and guidance on Regulation D offerings contemplate that a broker have a reasonable basis for recommending a product based on reasonable diligence, that does not necessarily mean independently verifying statements in a private placement memorandum. FINRA’s Rule 2310 (“Direct Participation Programs”) requires only that a broker or associated person have “reasonable grounds to believe, based on information made available to him by the sponsor through a prospectus or other materials, that all material facts are adequately and accurately disclosed and provide a basis for evaluating the program.” Rule 2310(b)(3)(A). That disclosure should include information on the following facts, if relevant: items of compensation; physical properties; tax aspects; financial stability and experience of the sponsor; the program’s conflict and risk factors; and appraisals and other pertinent reports. 2310(b)(3)(B). Under this rule, a firm may rely on another member’s inquiry into a product, provided that (1) the member has reasonable grounds to believe that the inquiry was conducted with due care, (2) the results of the inquiry were provided with the consent of the member conducting it, and (3) no member that participated in the inquiry is a sponsor or sponsor-affiliate of the program. 2310(b)(3)(C).
The rule disallowing reliance on the diligence of the sponsors themselves is consistent with case law holding that a broker may not rely on the representations of an interested party. Sorrell v. SEC, 679 F.2d 1323, 1327 (upholding disciplinary sanction, holding that broker could not reasonably rely on attorney’s advice that security was exempt from registration when the attorney was an interested party). Therefore Rule 2310 establishes that, at least in the case of direct participation programs (and arguably by analogy to other products), a firm is entitled to rely on information in a prospectus or other offering document, if it contains information sufficient to evaluate a program. Further, to the extent that additional inquiry is called for, a firm may rely on the diligence of another, provided that it is conducted with due care by a party independent of the issuer. If the firm is relying on third-party due diligence reports, the firm must follow up on any “red flags” revealed in the third-party reports, and independently verify issuer representations and information. See, e.g., Workman Securities Corporation, FINRA AWC No. 20090188184 (February 1, 2011).
As a general proposition of civil liability, there is no per se requirement for verification of statements made in offering documents. Rather, the need for such independent verification arises based on the unique facts of a particular issuer and offering. However, the due diligence obligation is a regulatory requirement under the rules of FINRA and other securities regulators, including but not limited to the requirements of FINRA Rule 2310 and Notices to Members 05-18 and 10-22. A due diligence obligation may also arise even absent specific regulatory requirements when red flags or other reasonable reasons for concern arise.
3. Due Diligence as Defenses to Fraud Allegations and to Regulatory Actions
Verification of information in offering documents remains an important best practice for broker-dealers for additional reasons. Although negligent due diligence currently is not, and should not be, recognized as an independent cause of action, FINRA arbitration panels sit in equity and are not required to adhere strictly to legal authority, so a purely legal defense may not preclude liability if the arbitrators believe more due diligence should have been done.
In addition, inadequate due diligence can pose difficulties in other contexts. The two most common situations, as observed by the court in BNP Paribas, are as defenses to alleged 10b-5 fraud and in regulatory disciplinary actions (due diligence is also a defense under certain state securities laws, see, e.g., California Corporations Code § 25504). Decisions of courts and the SEC reveal that, in some cases where additional caution is warranted, verification of representations will be necessary to successfully assert a due diligence defense to allegations of fraud or other securities rule violations.
- In the Matter of Capital Financial Services, Inc. and Brian Boppre, SEC Release No. 29887, 2011 WL 6288049 (Dec. 16, 2011). Respondents consented to a finding that it had willfully committed a 10b-5 violation when it did not conduct any diligence beyond reviewing unaudited financial statements and other materials from the sponsor. Although the sponsor paid for third-party due diligence by the due diligence law firm Mick & Associates, respondents did not follow up on the Mick report’s areas of concern. The reports noted the lack of audited financial statements, conflicts of interest, and that the offerings were collectively reporting a net operating loss, raising “red flags” that should have led to further investigation. This was especially so when the company was relatively young, with only two past private offerings, whose management had little experience in the oil and gas industry, there was no preexisting relationship between it and the broker, and was offering a high-dividend, high-risk investment.
- In the Matter of Thomas J. Fittin, Jr., SEC Release No. 29173, 1991 WL 292516 (May 8, 1991). Respondent was found to have acted with fraudulent intent and willfully violated antifraud provisions including 10b-5. Respondent acted as the selling agent for a new and unseasoned issuer, but did nothing more than review the offering materials which he characterized as too technical to be understood by laymen and made unsubstantiated inquiries of the issuer’s in-house staff and attorney. The SEC found that the small size of the offerings did not relieve the broker of his duty to investigate, and that the technicality of the oil and gas offering documents required him to either conduct a thorough investigation so that he understood them or refrain from selling them.
- In re Kevin Kunz, SEC Release No. 45290, 2002 WL 54819 (January 16, 2002). The Commission found that a broker had violated NASD’s just and equitable principles of trade when he had actual knowledge that a land transaction was effectuated primarily for the purposes of enhancing the issuer’s balance sheet. That real estate parcel appeared to give the company a positive net worth of $8 million, when it would have had a negative net worth of $800,000 without it. Knowledge of this major red flag triggered an obligation to investigate further, even when respondent claimed reliance on financial statements that were audited by an accountant.
In addition to serving as a shield against allegations of fraud and disciplinary complaints, verification of offering documents accuracy may sometimes be necessary when a broker wishes to advance its own claims against others. For example, the opinion In re Finley, Kumble, Wagner, Heine, Underberg, Manley, Myerson & Casey, 192 B.R. 342 (Bankr. S.D.N.Y. 1994), rejected a broker-dealer’s claims in bankruptcy against a defunct law firm that prepared factually incorrect PPMs. The bankruptcy court held that the broker’s fraud claims against the firm failed because it had a duty to discover incorrect facts in the PPM, and therefore its reliance on the firm to perform that investigation was unreasonable. 192 B.R. 342, 352-53.
4. Conclusion
Although there is no independent tort of “negligent due diligence” and FINRA regulations do not give rise to a private cause of action, there are many reasons that a broker-dealer should conduct reasonable due diligence before making investments available for sale by their associated persons. Judicial, SEC and FINRA guidance instruct that verification of the material contents of private placement memoranda and other offering documents is required for compliance and is important to defending against claims of fraud and in regulatory investigations. This is especially the case when there are sufficient red flags calling for independent inquiry of the issuer’s representations—either actual knowledge of possible inaccuracy, or when representations raise questions and there is a heightened duty of scrutiny because of the age and size of the offeror. In these situations, independent verification of representations made in offering documents may be necessary to establish an effective due diligence defense and to resolve legal questions calling into question the reasonableness of a firm’s reliance on such information.