Why Simply ‘Looking Into’ Wall Street’s Failure To Perform Adequate Due Diligence Isn’t Enough


The Securities and Exchange Commission has identified broker-dealer due diligence as an area of high risk. Before recommending any investment, a brokerage firm is required by law to have a reasonable basis for believing the investment is suitable for customers to whom the investment is recommended, and for understanding all the material facts (the pros and the cons) about the investment so that it can explain them to potential investors. The process by which the selling firm investigates a potential investment and learns the material facts about it is called due diligence. Due diligence is particularly important in recommending complex, non-publicly traded investments such as nontraded REITs.

The Financial Industry Regulatory Authority has also issued a number of notices to its member firms reminding them of their obligation to perform due diligence before recommending an investment. However, it has been our experience that, despite these “reminders,” firms often fail to perform adequate due diligence, essentially accepting the promoter’s assertions about the offering uncritically. Lack of due diligence has resulted in significant losses to investors, regulatory actions, lawsuits and arbitrations by aggrieved investors. Ultimately, the failure to perform due diligence has resulted in the collapse of numerous smaller broker-dealers under the weight of their legal liabilities.

Broker-dealers are also required to provide training sufficient to ensure that their registered representatives have a thorough understanding of the securities they sell. Again, firms have failed miserably in this regard. Over and over, representatives have demonstrated a lack of understanding of structured products, nontraded REITs, and other private investments, and have often frankly admitted that they just followed sales scripts.

In the midst of these problems, which have existed for a long time, an SEC official was quoted as saying, “We’re looking at due diligence.” (“SEC warns B-Ds to do their homework,” by Bruce Kelly, InvestmentNews).

The reasons why there is a lot of “looking at” the problem and little, if any, effective action being taken are twofold. First, many regard the SEC as a captive agency because of its revolving door and chummy relationship with Wall Street. Second, even assuming the SEC has the right kind of culture to take on Wall Street, there is a lack of political will in Washington to provide the necessary resources for successful regulation and oversight ? perhaps because a majority of politicians in Washington are afraid to bite the hand that feeds them political contributions. There is no money in investor protection.

In the meantime, the SEC will continue to “look into” the lack of effective due diligence and the myriad other problems on Wall Street, and occasionally ask brokers whether they understand what they are selling ? thereby putting the onus on ordinary investors to perform due diligence on the brokerage firms that promise, in their advertising, to be their expert guides through the bewildering maze of financial and investment decisions.

Page Perry is an Atlanta-based law firm with over 170 years of collective experience maintaining integrity in the investment markets and protecting investor rights.