For many exempt market dealers (EMDs), especially those never registered before, there are a host of unfamiliar obligations that must be met, many of which are straightforward and administrative in nature (in many cases, third-party service providers offer cost-effective means of addressing many of these tasks).
Other tasks and obligations, such as suitability assessment and know-your-product obligations, can’t be easily performed by a supplier who relies on size and operational efficiency to make outsourcing an easy decision.
While suitability is at first instance an obligation of the registered salesperson of a dealer, subject to a second, perhaps third level of review, due diligence obligations rest first with the EMD and, by extension, the salesperson.
As a matter of efficiency and consistency, each EMD should undertake an appropriate level of due diligence that can and should be relied upon by the salesperson.
While larger dealers often have staff who can undertake a prudent review of products and services – a review that goes beyond simply confirming or accepting the often overly optimistic and positive statements of promoters, syndicators and wholesalers who understandably can only praise what they are offering – smaller dealers often do not have staff with the skills and experience to tear an offering apart, review lengthy documents, conduct background checks and perform other due diligence.
In 2005, the MFDA felt the need to issue a notice to its members confirming the obligation of mutual fund dealers and their salespersons to conduct due diligence on the securities they recommend and/or sell to their clients, including prospectus-exempt securities. The position of the MFDA is equally applicable to EMDs dealing with the investing public.
Selling so-called exempt securities can be challenging for small mutual fund dealers that often don’t have the financial or human resources to establish, maintain, perform and enforce due-diligence-related policies and procedures. The more sophisticated the exempt security, the greater the level of due diligence required, and the more extensive the skills needed to look into the matter.
Dealer policies should limit salespersons to the sale of securities that are on an approved list and require annual written confirmation of compliance. Back-office staff should be trained to process orders only for securities on the approved list and bring to the attention of compliance staff any commissions or other payments received and tagged to a specified salesperson from parties not on the approved list.
A dealer’s written policies and procedures for selling exempt securities should reflect how the dealer will carry out due diligence, including:
The dealer’s senior officers’ considerations and approval of a comprehensive written recommendation with backup documentation, prepared by a trained individual who describes in detail the due diligence undertaken. This person should not report to, or through, a sales or marketing function. And the individual’s compensation should not be tied to the revenue or profit generated by the exempt security. Limited reliance should be placed on due-diligence reports directly paid for by the principals of an offering (or affiliated parties).
The retention of experts is often appropriate to advise on the reasonableness of forward-looking statements – including projections, estimates and forecasts – or to assess costs, revenue and overall feasibility of development projects. Experts with industry experience, whether real estate, oil and gas or some other industry, can provide the comfort an EMD needs for selling a prospectus-exempt security.
Requiring approved persons, who sell an exempt security, to have both the knowledge and experience to understand the security and explain its features, positive and negative, to potential investors.
Establishing and following a due-diligence program with these characteristics allows a dealer to demonstrate to regulators, and approved persons, that a satisfactory program is being applied. This will increase the dealer’s comfort in promoting exempt securities. It will also show a court that due diligence was performed prior to selling a security in the event of an allegation of breach of contract, breach of fiduciary duty, and/or negligence. Having an outside expert with appropriate credentials and experience goes a long way to establish appropriate due diligence was undertaken.
A due-diligence program is a necessary reputational risk-management tool.