Specific Due Diligence Requirements

 1.         Minimum Broker-Dealer requirements for new stock/bond offerings and direct participation programs (see ScoreCard analysis):

 A.              Fairness of “Use of Proceeds”

 B.              Fairness of division of revenues

C.              Operating stage – risks and conflicts

D.              Termination stage

E.               Incentives for sponsor to promote program

F.               Degree of marketing support

G.              Risk vs. reward evaluation

H.              Amount of un-invested proceeds from prior sponsored investments

2.         Minimum Account Executive requirements for any security sold

 

A.                 The broker has a duty to investigate stocks he recommends to his client.  Securities Exchange Act of 1934, # 10(b),

 15 U.S. C. A. , # 78j(b).

 B.                  To recommend an investment only after studying it sufficiently to become informed as to its nature, price and financial prognosis.  SEC releases and NASD (FINRA) Notices to Members.

 C.                  A corollary to “Know Your Customer” is the requirement that brokers know the nature and risks of the securities they recommend.  The duty to know the securities recommended to customers stems from a 1962 release which states that, “the making of recommendations for the purchase of a security implies that the dealer has a reasonable basis for such recommendations, which, in turn, requires that, as a prerequisite, he shall have made a reasonable investigation.”  SEC Act Release No. 4,445 (Feb. 2, 1962).

 D.                 Section 11 of the Securities Act of 1933 states, “no person, other than the issuer, shall be liable,… who shall sustain the burden of proof…that he had, after reasonable investigation, reasonable ground to believe and did believe, at the time such part of the registration statement became effective, that the statements therein were true, and that there was no omission to state a material fact required to be stated therein….”

 1.               What is the standard of reasonableness?  Section 11(c) states that the standard of “reasonableness” is that “of a prudent man in the management of his own property”.

2.               Who may be liable?  If there is a material misstatement or omission the following may be liable:

 (a)       the issuer;

 (b)       every person who signed the registration statement;

(c)       every person who was a director or partner of the issuer.

(d)       every person who is named (with their consent) as a director or “future director”.

(e)       every accountant, engineer, appraiser, or other “expert” whose profession gives authority to his statement, who is named as

having prepared or certified any part of the registration statement and;

(f)       every underwriter of the security.

 (g)      every broker dealer that was part of the selling group that sold the security

 

              Securities Act of 1933 – Rule 176 – In determining whether or not the conduct of a person constitutes a reasonable investigation or a reasonable ground for belief, meeting the standard set forth in Section 11 (c) of the Securities Act, relevant circumstances include, with respect to a person, other than the issuer:

                          a.  The type of issuer;

                         b.  The type of security;

                         c.  The type of person;

                         d.  The office held when the person is an officer;

                         e.  The presence or absence of another relationship to the issuer when the person is a director or proposed director;

                         f.  Reasonable reliance on officers, employees , and others whose duties should have given them knowledge of the particular facts;

                         g.  When the person is an underwriter, the type of underwriting arrangement, the role of the particular person as an underwriter and the availability of information with respect to the registrant; and

                         h.  Whether, with respect to a fact or document. incorporated by reference, the particular person had any responsibility for the fact or document at the time of filing, from which it was incorporated.

 

1.               What is a material fact?  In determining whether a registration statement is materially misleading, the “central inquiry” is “whether the defendants’ representations, taken together and in context, would have misled a reasonable investor about the nature of the investment” I. Meyer Pincus, 936 F 2d at 761 (citation omitted)  A material fact is one that “would have been viewed by the reasonable investor as having significantly altered the “total mix” of information made available.” DeMaria 313 F 3d at 180 (citation omitted).  See also Ganino v. Citizens Util. Co. 228 F 3d, 154, 162 (2d Cir. 2000).

 

2.         What is an omitted material fact?  An omitted fact may be immaterial if it is “trivial” or “so basic that any investor could be expected to know it”  Ganino, 228 F.3d at 162 (citation omitted).  Materiality remains, however, “a mixed question of law and fact”  Ganino, 228 F.3d at 162.  “A fact is material if its disclosure would change the total mix of facts available and there is substantial likelihood that a reasonable shareholder would consider the facts important to his or her investment decision”.  Basic, Inc. v. Levinson, 485 U.S. 224, 231-232, 240 (1988).  Finally, since materiality is a fact specific inquiry, courts within the Second Circuit have “consistently rejected a formulaic approach to assessing the materiality” of misrepresentations.  Ganino, 228 F.3d at 162.

 

              E.  Due diligence responsibility of Registered Investment Advisors:

 

                        1.  Section 206 (2) of the Investment Advisors Act of 1940 states, “It

                             shall be unlawful for any investment adviser, by use of the mails or

                             any means or instrumentality of interstate commerce, directly or in-

                             directly, to engage in any transaction, practice or course of business,

                             which operates as a fraud or deceit on any client or prospective client”.

 

                         2.  To promise to perform due diligence or to say or give the impression

                              that you did, and in fact, not to conduct a reasonable investigation is a

                              willful violation of Section 206 (2) of the Investment Advisers Act.

 

                         3.  A willful violation of the securities laws means merely “that the person

                              charged with the duty knows what he is doing.”  Wonsover v. SEC, 205 F.3d

                              408, 414 (D.C. Cir. 2000) (quoting Hughes v. SEC, 174 F.2d 969,977 (D.C. Cir.

                              1949)).

 

                         4.  There is no requirement that the actor “also be aware that he is violating one of

                              the Rules or Acts.”  (quoting Gearhart & Otis, Inc. v. SEC, 348 F.2d 798, 803 (D.C.

                              Cir. 1965)).

 

 

 

DUE DILIGENCE PROCESS WITHIN BROKER DEALERS

 

 

1.         AS PART OF THE SELLING GROUP

Credit report checks – Individuals & entities

FBI checks through NASD (FINRA) personnel files

Corporate legal counsel review of offering materials

Internal analysis of projections/forecasts

 

           Utilization of outside legal & special consultants

 

Audit financials

Asset verification

Track record verification

Banking, legal & accounting references are called to discuss lawsuits, audits, regulatory problems and any financial strength concerns.

 

Sponsor & asset verification

 

Regulatory bodies

– Review of county records to physically inspect title & grant deeds for proper vesting & form.  Records are checked for outside liens/judgments and currency of taxes.

Bank references

Supplier references

Investor verification

Visit to headquarters

– Write-up and analysis of sponsors accounting, compliance & organization procedures. Interviews with key mgmt. personnel.

Property verification

 

Independent competition study

Interviews with on-site management/construction personnel

 

Program monitoring (with a min. of $300,000 raised)

 

Computer tracking – outside counsel to audit

Regular summaries provided to registered representatives

 

2.         PLACEMENT AGENT OR UNDERWRITER:

*          Management

 

(a)             Individual interviews with all senior officers

(b)       Verification of background – College, previous employment, criminal record, credit history (bankruptcy?)

(c)       Objectives

(d)       Business Plan

 

*          Previous History of Corporation

(a)       Profit & Loss Analysis-dependence upon key supplier or customer

(b)       Cause for need for Capital

(c)       Product line, mix, marketing

(d)       Patents or trademarks

 

*          Physical Inspection of Facilities

(a) Capabilities of equipment – Serviceability, Potential for breakdown and effects

 

(b)       Building or Property – Sufficient for needs?  Length of lease, flexible for growth or lack thereof

 

(c)       Process of production – Follow chain of supply-(potential for raw material shortages).  Key personnel or employees.  Unusual expertise required.

 

 

*          Legal Organization

(a)       Inspection of legal documents – By-laws, Minutes, Corporate powers.

 

(b)       License or regulatory restrictions – Determine city, state, and federal restrictions on proposed business activities.  Cost of compliance.

 

 

*          References

(a)       Independent verification – Auditors, accountants, banks & credit bureaus, attorneys, suppliers & customers

 

(b)       Competition (most important)

(c)       Use outside experts, where possible, for analysis of business plan

 

*          Financial Review

(a)       Balance sheet review (before + pro-forma)

(b)       Use of Proceeds

(c)       Organizer’s investment – are they at risk?

(d)       Potential for profit – P/E analysis, Units-market potential realistic, Gross revenues

 

(e)       Revenue needed to obtain 5/10/20% return on shareholder’s equity

(f)        Management commitment to profitability

 

3.         Advertising and Communications –

 

All advertisements that refer to specific recommendations, including research reports, shall contain all proper disclosures of the NASD (FINRA) Conduct Rule 2210 (d) (2) (B).  The following must be disclosed when applicable:

 

 

                                    (a)       That the member usually makes a market in the securities being recommended, or in the underlying security if the recommended security is an option, and/or that the member or associated persons will sell to or buy from customers on a principal basis.

 

(b)       That the member and/or its officers or partners own options, rights or warrants to purchase any of the securities of the issuer whose securities are recommended, unless the extent of such ownership is nominal.

 

 (c)       That the member was manager or co-manager of a public offering of any securities of the recommended issuer within the last three years.

 

 

Beginning in approximately the year 2000, 3rd. Party Due Diligence Firms began to perform in-depth analysis on both the sponsors and their programs.  These independent entities made their due diligence reports reports available solely to broker-dealer members of the selling group that participated in the distribution of these DPP programs.  It was custom and practice in the DPP industry that while the sponsor paid for the reports, there was no guarantee or assurance that the report would be favorable.  The fees paid to the outside firms would not be dependent in any way upon the findings or conclusions of the due diligence report or completion of the offering.  This is how the 3rd party due diligence firms maintained their independence.  Further, each selling group member that availed itself of the report signed a statement that the report would not be shown in any manner to prospective investors.  They were for broker-dealer use only.  While these independent reports were no substitute for a firms own due diligence, they assuredly helped to verify and amplify the analysis done on the sponsor and program by the broker-dealers themselves.   The Buttonwood disclaimer states, “This report is intended to be part of the Broker/Dealer’s review, and it is not intended to cover all facets of the due diligence that a Broker/Dealer may require.  It should be noted that the FINRA Notice To Members # 05-48 addresses the responsibilities of the individual broker/dealer, suggesting they may not rely exclusively on the efforts of a third party provider.  While this report is designed to assist the broker/dealer in its due diligence efforts, it is not designed to replace it”.  A number of 3rd. Party Due Diligence firms surfaced after the year 2000 and include:

 

           Buttonwood Investment Co – Dana Woodbury                   Bryan Mick Reports

           Chris Cain                                                                          Miterko Reports

           FactRight Reports                                                              Pt. Loma – Nat Webster Reports

           Foley and Lardner                                                              Robert A. Stanger & Co.

           Marcus Hurlburt                                                                 Snyder Kearney LLC

           Rhode & Associates                                                           Joseph D. Steffe & Assoc.

 

In a Program Due Diligence Report, 3rd. party analyst Snyder Kearny LLC stated, “”We specifically note that given the limited scope of our representation, we may not have independently verified factual statements contained in the PPM.  Further, our review is subject to the budgeted hours and may or may not be sufficient to consist of a “reasonable investigation” or “reasonable care” as such terms are defined in Sections 11 and 12 of the Securities Act of 1933, as amended.  Unless expressly indicated in a separate legal opinion identified as such, we will not provide any opinion or legal advice regarding the adequacy of any investigation performed by us or the adequacy of the Offering disclosure, but rather will conduct an investigation within the budgeted time and advise as to the material results of that investigation.”

    In light of this disclaimer, broker dealers are clearly on notice that these 3rd party due diligence firms can not be relied upon to meet the “reasonable investigation” requirement set forth by FINRA regarding private placements.  This obligation rests solely with the broker dealer.  In summary, the due diligence responsibility of a broker-dealer could best be summed up by the basic “Know Your Customer Rule”.   It states, ”Use due diligence to learn the essential facts relative to every customer, every order, every cash or margin account accepted or carried by such organization and every person holding power of attorney over any account accepted or carried by such organization”.

 

 

Due Diligence of 1031 Offerings

April 25, 2007

 

10500 Little Patuxent Parkway

Suite 710

Columbia, MD 21044

(410) 964-2500

(410) 964-2057 – Fax

 

This paper has been prepared by Snyder Kearney LLC for informational purposes only and does not constitute legal advice. This information is not intended to create, and receipt of it does not create, an attorney-client relationship. Readers should not act upon this information without obtaining advice from their professional advisors.

 

Introduction

 

The offering of tenant-in-common interests in real estate to investors as a means of completing an exchange under Section 1031 of the Internal Revenue Code of 1986, as amended (a “1031 Offering”1), has grown dramatically over the past few years. Since most, if not all, 1031 Offerings involve the offer and sale of a security,2 they are sold through securities broker-dealers and are subject to legal standards applicable to securities offerings, including the liability provisions of the federal and state securities laws.

 

As discussed below, the National Association of Securities Dealers, Inc. (“NASD”) requires that broker-dealers conduct appropriate due diligence of 1031 Offerings. In addition, as is the case with all securities offerings, it is advisable for broker-dealers distributing the securities to perform appropriate due diligence of the offering to limit the potential for liability under federal and state securities laws.

 

In practice, much of the due diligence of 1031 Offerings is conducted on an outsourced basis by law firms and other providers, and varies widely in a number of respects, including:

 

• Whether it is being conducted at all;

• The scope of the due diligence review, including whether what is being offered as due diligence actually constitutes due diligence within the meaning of the securities laws;

• The qualifications of the persons conducting due diligence; and

• Whether the persons conducting the due diligence have been retained by the sponsor or the broker-dealer.

 

 

In light of this variation, broker-dealers may not be in compliance with NASD requirements or receiving the protections against liability that appropriate due diligence offers, and may unknowingly be exposing themselves to undue risk. Further, NASD has reminded its members of their obligation to conduct their own due diligence of service providers, such as due diligence service providers, to which they outsource certain activities.

 

      In order to assist broker-dealers in (i) determining the adequacy of due diligence being conducted in connection with 1031 Offerings in which they are participating, and (ii) performing due diligence on providers of due diligence services, this paper provides information concerning the purpose of due diligence and due diligence standards established by the courts and regulatory authorities, and makes recommendations concerning the appropriate scope of due diligence of a 1031 Offering and the qualifications of due diligence providers.

 

1 In addition to offerings of tenant-in-common interests, some 1031 Offerings involve the offer and sale of interests in a Delaware Statutory Trust. Unless the context indicates otherwise, references in this paper to 1031 Offerings include both types of offerings.

 

2 While some sponsors of 1031 Offerings take the position that their offerings are structured as the offer and sale of real estate and not a security, there is limited authority for such a position. While it is beyond the scope of this paper to analyze the issue of whether a 1031 Offering involves a security or real estate, prudent market participants should treat all syndicated 1031 Offerings as involving the offer and sale of a security.

 

1

 

3 15 U.S.C.A. § 77k(a).

 

4 15 U.S.C.A. §§ 77k(b)(3)(A), 77k(b)(3)(B).

 

5 15 U.S.C.A. § 77l(a)(2).

 

6 Since Section 11 relates to disclosures in a registration statement, it applies only to registered offerings. In 1995, the Supreme Court in Gustafson v. Alloyd Co., 115 S. Ct. 1061 (1995), determined that Section 12 liability is limited to public offerings as private offerings do not involve the use of a “prospectus” as that term is defined in the Securities Act.

 

7 15 U.S.C.A. §§ 78j(b), 78u-4(b)(2); 17 C.F.R. § 240.10b-5.

 

8 Comshare Inc. Sec. Litig., 183 F.3d 542 (6th Cir. 1999).

 

Reasons for Conducting Due Diligence

 

Federal Securities Laws

 

The concept of securities offering due diligence was incorporated in the Securities Act of 1933, as amended (the “Securities Act”). Generally, Section 11 of the Securities Act imposes liability on certain persons, including persons who signed the registration statement, directors of the issuer, and underwriters, when a registration statement contains an untrue statement of a material fact or omits to state a material fact required to be stated therein or necessary to make the statements therein not misleading.3 Persons other than the issuer are not liable with respect to any part of the registration statement, however, if they “had, after reasonable investigation, reasonable ground to believe, and did believe, at the time such part of the registration statement became effective, that the statements therein were true and that there was no omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading[.]”4

 

 

 

 

 

Similarly, Section 12 of the Securities Act imposes liability on a person who offers or sells a security by means of a prospectus or oral communication, which includes “an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading,…and who shall not sustain the burden of proof that he did not know, and in the exercise of reasonable care could not have known, of such untruth or omission[.]”5

 

Thus, as the forgoing quoted language indicates, Section 11 and Section 12 each includes a defense against liability for persons who conducted reasonable due diligence.

 

Since 1031 Offerings are conducted pursuant to an exemption from the registration provisions of the Securities Act, however, Sections 11 and 12 do not apply.6 Therefore, a plaintiff seeking redress under the federal securities laws in connection with a 1031 Offering would likely allege fraud pursuant to Section 10b-5 of the Securities Exchange Act of 1934, as amended. While for a person to be liable under Section 10b-5, the plaintiff must demonstrate that the person must have possessed some degree of “scienter,”7 generally, cases have held that the scienter requirement can be satisfied by showing that the defendant acted with recklessness, which has been described as “a mental state apart from negligence and akin to conscious disregard[.]”8

 

2

 

9 15 U.S.C.A. § 78j(b); 17 C.F.R. § 240.10b-5.

 

10 For example, the Federal District Court for the Southern District of California found an underwriter was not reckless where it had performed substantial due diligence. In re Software Toolworks, Inc. Sec. Litig., 50 F.3d 615, 623 (9th Cir. 1994); In re Software Toolworks, Inc. Sec. Litig., 789 F.Supp. 1489, 1497 (N.D.Cal.1992).

 

11 In an administrative proceeding, the SEC has held that soliciting investors for a private placement without validating information supplied by third-party promoters constituted recklessness. In the Matter of Stires & Co., Inc. and Sidney H. Stires, 67 S.E.C. Docket 1716 at 7 (1998).

 

12 Anheuser-Busch Companies, Inc. v. Summit Coffee Co., 934 S.W.2d 705 (1996); 15 U.S.C.A. § 77l(a)(2).

 

Thus, simple negligence on the part of a broker-dealer in connection with a 1031 Offering should not be sufficient to subject it to liability under 10b-5, but recklessness or “conscious disregard” likely would be.9 While there is no express “due diligence” defense to liability under 10b-5, it would be difficult for a plaintiff to demonstrate recklessness on the part of a broker-dealer where it conducted an appropriate degree of due diligence before participating in the offering.10 Conversely, if investors were to experience a loss in a 1031 Offering and offering disclosure was arguably inaccurate or misleading, a plaintiff almost surely would pursue a claim against a broker-dealer that sold the offering with no or inadequate due diligence, arguing that the broker-dealer was reckless in doing so.

 

 

 

 

 

11 State Securities Laws

 

Although Section 12 of the Securities Act does not apply to private securities offerings such as 1031 Offerings, states may have similar liability provisions, including a due diligence defense, that do apply. For example, article 581-33(A)(2) of the Texas Securities Act provides, in part:

 

A person who offers or sells a security (whether or not the security or transaction is exempt under Section 5 or 6 of this Act) by means of an untrue statement of a material fact or an omission to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they are made, not misleading, is liable to the person buying the security from him, who may sue either at law or in equity for rescission, or for damages if the buyer no longer owns the security. However, a person is not liable if he sustains the burden of proof that either (i) the buyer knew of the untruth or omission, or (ii) he (the offeror or seller) did not know, and in the exercise of reasonable care could not have known, of the untruth or omission.

The Court of Appeals of Texas has ruled that this statute applies to private offerings, noting that it does not contain the phrase of limitation “by means of a prospectus or oral communication” present in Section 12 of the Securities Act.12 Thus, under Texas law, sellers (including broker-dealers) can protect themselves from liability by conducting due diligence to satisfy the “reasonable care” standard for avoiding liability under the statute.

 

3

 

13 15 U.S.C.A. § 77k(c).

 

14 15 U.S.C.A. § 77l(a)(2).

 

NASD Requirement

 

NASD requires that its members conduct due diligence of 1031 Offerings in connection with their reasonable basis suitability analysis. NASD Notice to Members 03-71 (“NTM 03-71”), which pertains to “non-conventional investments” (“NCIs”), reminds members that the sale of NCIs, like more traditional investments, requires them to conduct appropriate due diligence with respect to these products. NTM 03-71 states the following:

 

A reasonable-basis suitability determination is necessary to ensure that an investment is suitable for some investors (as opposed to a customer-specific suitability determination…which is undertaken on a customer-by-customer basis). Thus, the reasonable-basis suitability analysis can only be undertaken when a member understands the investment products it sells. Accordingly, a member must perform appropriate due diligence to ensure that it understands the nature of the product, as well as the potential risks and rewards associated with the product.

While NTM 03-71 does not specifically identify 1031 Offerings as NCIs, NASD Notice to Members 05-18 (“NTM 05-18”), which is discussed below, does. Thus it is clear, as far as NASD is concerned, that members have an obligation to conduct due diligence of 1031 Offerings.

 

Due Diligence Standards

 

The following is a brief summary of highlights of leading due diligence cases generally and an important regulatory pronouncement that specifically addresses due diligence of 1031 Offerings.

 

Case Law

 

There is a substantial body of case law on the subject of due diligence, typically in the context of defense of a claim under Section 11 or 12 of the Securities Act. Among other things, these cases stress the need for:

 

• A high degree of care;

• An independent investigation of facts;

• Identification of all facts material to investors; and

• Non-reliance on management representations.

 

 

Under Section 11 of the Securities Act, the standard of care for the due diligence defense is “that required of a prudent man in the management of his own property.”13 Under Section 12, the standard is “the exercise of reasonable care.”14 Accordingly, the standard of care is essentially a negligence standard. Implicit in this standard should be that the persons

 

4

 

 

15 Escott v. BarChris Construction Corp., 283 F.Supp. 643, 696-697 (S.D.N.Y.1968).

 

16 Feit v. Leasco Data Processing Equip. Corp., 332 F. Supp. 581, 582 (E.D.N.Y. 1971).

 

17 BarChris at 697.

 

18 SEC Release No. 33-5275 (July 26. 1972).

 

conducting due diligence have the qualifications and experience necessary to do so. A leading due diligence case found the due diligence investigation insufficient because it did not identify material facts and noted the inexperience of the attorney supporting the process.15

 

The cases also stress that due diligence be conducted in an independent manner and identify all material facts:

 

[Dealer-managers] are expected to exercise a high degree of care in investigation and independent verification of the company’s representations. Tacit reliance on management assertions is unacceptable; the underwriters must play devil’s advocate.16

The purpose of Section 11 is to protect investors . . . To effectuate the statute’s purpose, the phrase ‘reasonable investigation’ must be construed to require more effort on the part of the underwriters than the mere accurate reporting in the prospectus of ‘date presented’ to them by the company . . . In order to make the underwriters’ participation in this enterprise of any value to the investors, the underwriters must make some reasonable attempt to verify the data submitted to them. They may not rely solely on the company’s officers or on the company’s counsel.17

[B]ecause the participation of the underwriter is central to the successful distribution of the securities, the underwriter is peculiarly able to demand access to information . . . The underwriter may not always rely on the truthfulness of information supplied by the issuer.18

 

 

It is noteworthy that the BarChris court said that the due diligence investigation was inadequate where the attorney:

 

• Accepted assurances that missing board minutes related to only routine matters;

• Failed to examine key contracts to discover they hadn’t been signed;

• Failed to investigate financial difficulties between company and lender; and

• Generally failed to verify information submitted by the company.

 

 

In the context of a 1031 Offering, this calls into question the adequacy of a “due diligence” investigation that merely reviews and summarizes information contained in the offering document.

 

Although the concept of due diligence initially arose as a defense against liability, the SEC and others have characterized due diligence as not only a defense but an implied requirement of underwriters.

 

5

 

19 In re Richmond Corp., 41 S.E.C. Docket 398, 406 (1963).

 

20 In re Thomas J. Fittin, 50 S.E.C. Docket 544, 549 (1991).

 

By associating himself with a proposed offering, an underwriter impliedly represents that he has made such an investigation in accordance with professional standards . . . The underwriter who does not make a reasonable investigation is derelict in his responsibilities to deal fairly with the investing public.19

The small size of [the] offerings did not relieve [the president of a brokerage firm] of his duty to investigate. If, as he contends, he lacked the experience in oil and gas drilling programs to understand [the issuer’s] materials, it was necessary . . . for him to acquire that understanding. His choice was clear – either conduct a thorough, independent investigation or refrain from selling these initial limited partnership offerings by a relatively new and unseasoned issuer.20

 

NASD Guidance on 1031 Offering Due Diligence

 

NASD NTM 05-18 addresses a number of issues relating to 1031 Offerings, including due diligence. NTM 05-18 states that “NASD staff believes that it is not appropriate for members that recommend a [Tenant in Common] transaction simply to rely on representations made by the sponsor in an offering document.” It also states that “members should make a reasonable investigation to ensure that the offering document does not contain false or misleading information.” According to the notice, such an investigation could include:

 

• Background checks of the sponsor’s principals;

• Review of the agreements (e.g., property management, purchase and sale, lease and loan agreements);

• Property inspection; and

• An understanding of the basis for projections, the degree of likelihood that they will occur and a determination whether projected yields can reasonably be supported by the property operations.

 

 

Who Should Conduct Due Diligence

 

Obviously, persons conducting due diligence should possess the expertise necessary to perform an adequate review, and unqualified persons should not be retained for this purpose. The BarChris case noted the inexperience of the person supporting the due diligence investigation and found the due diligence investigation insufficient because it did not identify material facts. In addition, as discussed below, NASD has advised members that they should investigate whether those to whom they outsource certain activities are capable of performing them.

 

6

 

21 Neither NTM 05-48 nor Rule 3010 provides a comprehensive list of activities that are covered activities. We contacted the NASD attorney listed as the contact person for NTM 05-48, and were advised that NASD staff is not providing specific guidance on what constitutes a covered activity. Rather, the guidance is that if the activity – in this case due diligence – would be required to be the subject of a supervisory system and written supervisory procedures if performed directly by the member, it would be considered a covered activity.

 

NASD Notice to Members 05-48

 

NASD Notice to Members 05-48 (“NTM 05-48”) addresses the practice of broker-dealers contracting with third-party service providers to perform certain activities and functions on a continuous basis. It states that if a member, as part of its business structure, outsources “covered activities,” which are activities that, if performed directly by the member, would be required to be the subject of a supervisory system and written supervisory procedures pursuant to Rule 301021, its written supervisory procedures must include procedures regarding its outsourcing practices to ensure compliance with applicable securities laws and regulations and NASD rules.

 

 

 

 

 

The NTM further states that the procedures “should include, without limitation, a due diligence analysis of all of its current or prospective third-party service providers to determine whether they are capable of performing the outsourced activities.”

 

Accordingly, it is incumbent upon broker-dealer firms to have written supervisory procedures relating to their outsourcing practices, including outsourcing of due diligence, and to conduct due diligence of their service providers, including their due diligence providers.

 

Recommended Scope of 1031 Program Due Diligence

 

The following is a recommended scope of 1031 Program due diligence. This recommendation is based upon the concept that a principal purpose of due diligence is to ensure that offering disclosure is accurate and complete. Accordingly, an appropriate due diligence review should cover those items necessary for making such a determination. While Section 11 of the Securities Act is not applicable to private 1031 Offerings, the Section 11 due diligence standards, including an investigation that a prudent person would undertake in the management of his or her own property, provide excellent guidance as to what constitutes a reasonable due diligence investigation. The review should also be based upon the guidance issued by NASD in NTM 05-18. Of course, the appropriateness of the scope of any due diligence review depends upon the particular facts and circumstances of the offering and the sponsor.

 

7

 

The following appear to be some of the items that a prudent person would investigate in connection with a review of a specific 1031 Offering:

 

• Offering documents: Private Placement Memorandum (“PPM”) and appendices;

• Operative agreements: Tenant in Common (“TIC”) purchase agreement and escrow instructions; TIC agreement; management agreement; master lease;

• Loan documents: mortgage, note, guaranty, environmental indemnity;

• Tenants: current rent roll, leases, tenant financial statements, SEC filings for public company tenants, other tenant credit information;

• Tax: tax opinion, representation letter, PPM disclosure;

• Third-party reports: appraisal, environmental, property condition;

• Property: site visit;

• Market: sales and rent comparables, area analysis;

• Title: title commitment, Schedule B exception documents, survey; and

• Projections: sponsor projections in PPM, sponsor Excel or Argus file.

 

 

These items should be obtained, reviewed, and analyzed, all with a goal of ensuring the adequacy of offering disclosure and of identifying business terms or issues that may have a bearing on the broker-dealer’s decision whether to offer the program to its customers.

 

In addition to specific property-level due diligence investigations, it is advisable periodically to conduct a sponsor-level review. An appropriate sponsor review will identify issues relating to the sponsor that may warrant disclosure in offering documents, and will provide the broker-dealer with information to consider in determining whether it wants to participate in the sponsor’s 1031 Offerings.

 

 

The following appear to be some of the items that a prudent person would investigate in connection with a review of a 1031 Offering sponsor:

 

• Organizational structure and control;

• Material contracts;

• Litigation;

• Regulatory compliance;

• On-site management interviews;

• Background investigations;

• Reference checks;

• Management and staff capability analysis;

• Review of policies and procedures;

• Financial statement review;

• Prior performance review;

• Prior performance disclosure;

• Overall performance;

• Identification of problem properties; and

• Analysis of internal controls and procedures.

 

 

As these items indicate, a due diligence review is substantially more than a summary of information presented in the sponsor’s offering documents. Unfortunately, program and

 

8

 

sponsor due diligence reviews of this or a similar scope are not always compatible with the desire of some sponsors and broker-dealers involved in 1031 Offerings. Reasons might include the unwillingness of a sponsor to subject itself or its program to the scrutiny due diligence involves, an unwillingness of the sponsor to reimburse the cost of a due diligence review, and the desire on the part of the broker-dealer, for business reasons, to sell the offering regardless of the adequacy of due diligence.

 

Recommended Qualifications and Independence of Due Diligence Providers

 

As indicated above, case law establishes that due diligence be conducted with a high degree of care by persons who are qualified and are independent of the issuer.

 

Substantive Qualifications

  

 Finally, in conducting its reasonable investigation, broker dealers are often cautioned  by respondent firms that as part of its due diligence, there is no need to look for Audited Financial Statements because there weren’t any!  This assertion just isn’t so.  There were a number of Private Placement Sponsor’s, including real estate, equipment leasing and oil and gas companies that did in fact have their financial statements audited.   Copies of those audited statements are part of my securities expert witness file.

 

TIME AND PRICE DISCRETION

 

     An exception to having to obtain prior written authorization to trade an account on behalf of a customer is Time and Price Discretion.  NASD Conduct Rule 2510 describes this activity.  Per 2510 (d) (1), the Rule shall not apply to:

      (1) discretion as to the price at which or the time when an order given by a customer for the purchase or sale of a definite amount of a specified security shall be executed.

 Time and price discretion can be defined as verbal permission to have some flexibility as to the exact time and exact price in which a broker executes the order for the customer.  It is measured in minutes, hours and to the end of the business day, not longer. The Practising Law Institute’s Securities Arbitration 1994 states, “not only in the practical world of brokerage transactions, but in arbitration where it has become a favorite defense to unauthorized trading claims….the NYSE measures time and price discretion in hours or days not in weeks.  Therefore, a[n alleged] time and price discretion that lasts more than a day or two is questionable and most likely [is] a violation.  If a broker wishes to take longer to enter a trade for his client, he has two other options – call the client back or use a Good Till Cancelled (GTC) order ticket.”  Current NASD rules limit time and price discretion to the end of the business day.

 

                                           RECORD RETENTION

 

SEC Rules 17a-3 and 17a-4 describe Records to be Preserved by Certain Exchange Members, Brokers and Dealers.  They provide that “Every such broker and dealer shall preserve for a period of not less than six years”:

 

     Ledger Accounts (or other records) itemizing separately as to each cash and margin account of every customer and of such member, broker or dealer and partners thereof, all purchases, sales, receipts and deliveries of securities and commodities for such account and all other debits and credits to such account.

 

     Any customer account cards or records which relate to the terms and conditions with respect to the opening and maintenance of such account.  These new account records shall be preserved for a period of not less than six years after the closing of any customers account

 

     New Account Information Forms (after account closed)            6 years

 

     New Account form – Options, Margins, etc. (after acct. closed)6 years.

 

     Customer Account Statements                                               6 years

 

     Securities Log./Blotter                                                           6 years

 

     Copies of Customer Checks/Cancelled Checks                        6 years

 

     Copies of written communications with the client or notations

 

          documenting client contacts and correspondence with the

 

          Compliance Department regarding the account                     6 years

 

     Investment Application for Checks (copies)                                 3 years

 

     Daily Trading Logs, Written Order Tickets, Daily Trade Rep.       3 years

 

     All Customer Correspondence & Customer Complaints              3 years

 

     Advertising – Radio and Newspaper Ads.  All Brochures.             3 years

 

     Employee Records (after termination), U-4 forms                       3 years

 

     Written Agreements (contracts)                                                   3 years

 

     Company Directives                                                                     3 years

 

     Registered Representative Commissions                                    2 years

 

     Securities Received Logs & Transmittal Forms                           2 years

 

     Compliance Notes                                                                       1 year

 

 

 

 

 

                                         LESSONS LEARNED

 

                                   Famous Financial Meltdowns

 

 

 

1981 – Nov. 18 – A Tale of Two Conferences

 

          Imagine a time when massive loans to deadbeat nations threatened to bring down the worlds banking system.  Re-arranging bad loans, the pundits said, is like “re-arranging deck chairs on the Titanic.”  That was 1981 not 2008. But behind the scenes, New York banking and Reagan-era Treasury officials quietly negotiated with Latin American debtors, offering to reschedule their debts, at lower interest rates, in exchange for political concessions – such as free elections.  Throughout the 1980’s, military leaders were replaced by democracies.  As a result of increased economic freedom south of the border, by 1994, external debt as a percent of GDP declined by fully half in most major Latin American nations:

 

*  In Chile, external debt fell from 109% of GDP) in 1987 to 42% by 1994.

 

*  Argentina’s debt fell from 58% of GDP to 31%.

 

*  Mexico’s debt fell significantly, from 79% of GDP to 44%.

 

*  Brazil reduced its external debt to just 25.8% by 1994

 

Recently, most South American markets have been soaring, and Brazil is hosting the 2016 Olympics.  But in 1981, they seemed to be going under.  Crisis rating: 5

 

 

 

1988 – Drexel Burnham Lambert

 

     The firm that created the junk-bond king (Ivan Boske) and made corporate raiders look like the heroes of Raiders of the Lost Ark.  Also the firm that temporarily destroyed the reputation of the junk-bond market and made corporate raiders look like evil-hearted pirates.  Estimated loss:  $1 billion – Crisis rating: 3

 

1989/90 – Saving and Loan Crisis – Bank Failures and a 10-Year Market Malaise

 

     Imagine a time when many of America’s biggest banks made terrible bets on overpriced real estate and suffered huge losses.  While America’s banks insisted they were solvent, politicians declared them insolvent and took them over, in a recession, making matters worse.  And, a stock market crashed and stayed down for 19 years.  In addition to the Savings & Loan crisis, there was also the Japanese stock market, which crashed by about 75% in 1990 and has not recovered yet.  The U.S. stock market fell much less, about 20% in three months, from July to October just as it later did in 1998.  The scary talk of the time was that taxpayers would have to shell out over $500 billion to unwind the leveraged debts.

 

     Hundreds of bankers (plus Ivan Boesky and Michael Milken) went to prison, but the unwinding of debts cost only a fraction of published fears.  Alan Greenspan wrote in “Age of Turbulence,” page 117: “By the time it disbanded in 1995, the RTC had liquidated 744 S&L’s – more than a quarter of the industry.  But thanks in part to the asset sales, the total bill to taxpayers was $87 billion, far less than originally feared”.

 

     Lax regulation of standards combined with increasing liquidity for S&L’s create a housing bubble in the 1980’s which eventually bursts, causing the federal government to bail out S&L’s.  Estimated loss:  $150 billiion Crisis rating: 8

 

 

 

1991 – BCCI

 

     Murky international banking conglomerate goes bust while relying on friends in high places to keep its losses from coming to light.  A state within an international financial corporation, its objective was to operate on the fringe of the global financial community, reportedly financing nefarious deals.  Estimated loss $20 billion – Crisis rating: 2

 

 

 

1995 – Barings Bank

 

     Old-money bank makes new money by accounting trickery in the form of trader Nick Leeson, who covers larger and larger losses by cooking the books.  Ushers in the phrase “Rogue Trader.”  Estimated loss:  $1.5 billion – Crisis rating:  2

 

1997 – Asian Currency Crisis

 

     Thai bhat goes bust, and spreads fear throughout the Asian Tiger economies.  some Asian leaders throw blame at George Soros.  First test of the new global economy after Soviet collapse, and economy scores a solid C+.  Estimated cost $1 trillion – Crisis rating: 10

 

1998 – Russian Currency Crisis

 

     Imagine a time when hedge funds made too many leveraged bets on currencies.  Their bad bets threatened to bring down the entire global financial system.  While it sounds like 2008, it was 1998.  Today marks the 11th anniversary of that “day of maximum pessimism” after the hedge fund crisis of 1998.  From mid-July to October 8, 1998, the S&P fell 19%.  The next day, (Friday, October 9, 1998, the market began to rise strongly, up 167 points in a day, to 7900.  Within six weeks, the Dow hit a new all-time high, on Nov. 23, at 9374, up 21% in 32 trading days.  There was a lot of leverage to unwind then, as now, but the world survived the 1998 hedge fund crisis.

 

     Closely related to the Asian currency crisis, the Russian ruble turns to bubble one year later.  Second test of the new global economy after Soviet collapse, and economy scores a B+.  Starts Vladimir Putin on his path to presidential power.  Estimated loss $11 billion, plus some loose change – Crisis rating: 6

 

2001 The Dotcoms

 

     Hype makes right in the New Era as young high-tech companies promise big in order to figure out how to make money later.  A company even tries to set up a business transmitting scents over the Internet.  Estimated loss:  Many billions + dignity – Crisis rating: 7

 

2007 – Market Meltdown

 

     Wall Street decides that historically high home prices means even poor credit risks need no equity to buy a house because housing prices will always go up a lot and, hey, we can just raise their interest rates if we get in trouble.  The market decides otherwise.  Estimated potential loss: $300 billion – Crisis rating: 8

 

 

 

                                                                                                                 Vol 1:1

Underwriters’ Due Diligence;

What Is It And How Much Is Enough?

– James P. Jalil, Esq., Senior Partner – Shustak Jalil & Heller, NY      

 

 

One often hears of underwriters “doing due diligence”. But what in fact is “due diligence”, why do underwriters have to do it and when is enough, enough? These are questions that have plagued underwriters and investment bankers for years with little, if any, guidance. Hopefully, this will help.

 

The story begins in 1929. In the wake of the stock market crash of that year and the Great Depression that followed it, it is not going too far out on a limb to suggest that by the early 1930s the American people had begun to lose confidence in our financial institutions. Chief among these financial institutions were the capital markets. Since capital is the engine that drives expansion, that confidence had to be restored.

 

Congress addressed this issue in a series of new laws that were adopted at the start of the New Deal, known today as the federal securities laws. The first such law that was passed was the Securities Act of 1933. While this Act has been amended and updated many times over the years, it remains the bedrock law governing the issuance and sale of securities both privately and publicly.

 

At its core the Securities Act of 1933 is a consumer protection statute. Recognizing that the whole point of the legislation was to restore and maintain investor confidence in the capital markets in general, and in new sales of securities in particular, the Act is designed to ensure two things. First, that the purchaser of a newly issued security (the Act has nothing to do with secondary trading) be given proper, adequate and meaningful disclosure. That is, that the investor be given enough honest information to understand what he or she is buying and the risks associated with such an investment. Second, that if the investor is defrauded, that is, if the information that was provided turns out to have been false, or something was omitted that ought to have been included to give the investor the whole story or a more accurate picture of the company issuing the securities, then the aggrieved investor can bring an action to recover damages.

 

It is the second element that concerns underwriters. In any underwritten public offering, whether best efforts, firm commitment, minimum/maximum, or otherwise, the basic structure is the same. The underwriter, who must be registered with the Securities and Exchange Commission as a broker/dealer and be a member of the National Association of Securities Dealers, purchases the securities from the company that is selling the security (the “issuer”) and resells those securities to the public. The difference in price between what is paid to the issuer and what is received from the public purchasers of the securities is the underwriter’s commission, or profit.

 

So what has all this to do with “due diligence”? Everything. Remember that at its core, the Securities Act of 1933 is a consumer protection statute designed to restore and maintain confidence in the capital markets. Prior to 1933, if a company committed fraud when issuing securities, naturally that company could be sued for what is known as common law fraud. If the company were found to have had committed fraud it would have to pay damages. But what if the fraud occurred during an underwritten public offering? Should the underwriters be at all liable? Well, the investment banking industry answered no, of course not. They argued that they were not guarantors of the veracity of the company’s disclosures, but were merely conduits that bought securities from the company and resold them to the public. Why should they be liable to anybody if the company lied? That was their position.

 

In the face of that, Congress answered with Section 11 of the Securities Act of 1933. Congress felt that many people purchased securities issued through an underwritten public offering at least in some measure on the reputation and standing of the underwriter. Therefore, Congress felt that underwriters should accept some responsibility for the securities they were reselling to the public. Part of that responsibility ought to include making sure that the securities they were underwriting, or passing on to the public, were not bogus. If things turned out not to be as advertised, then the underwriter ought to have some liability. Thus was born the concept of underwriter’s liability.

 

  Section 11 is simple in principle, yet complicated in practice. It states that in any underwritten public offering of securities, if the disclosure given the investor proves faulty in any material respect, the company is liable to the purchaser for the loss. That seems straight forward enough. But it goes further. It also says that if the securities were sold as part of an underwritten public offering, not only is the company liable, but the underwriter is also equally liable.

 

  Section 11 also defines the relative defenses available to both the issuer of the securities and the underwriter. In the case of the former, the answer is simple. The issuer has no defense. If the public offering disclosure document (the prospectus) is faulty in any material respect, the issuer is liable. Period. Even if the faulty disclosure was the result of a mistake or made in good faith, it does not matter. The issuer is strictly liable for any material disclosure that proves to be faulty. That however is not the case for the underwriter. The underwriter has a defense and that defense is to so-called “due diligence defense”.

 

Recall that prior to the Securities Act of 1933, underwriters argued that they ought not to be the guarantors of the veracity of the company’s disclosures. If the company lied to them, they argued, why should they be liable to the ultimate investors, when in fact they were as much a victim as anyone else? To some extent Congress understood that logic. On the other hand Congress did not want underwriters to stick their heads in the sand so to speak and be willing to re-sell securities to the public willy-nilly with no reality check. To address this tension Congress fashioned the due diligence defense.

 

Without quoting the technical language of Section 11, the way it works is this: An underwriter is equally liable along with the issuer of securities if there is a material misstatement of omission in the publicly offered disclosure document unless, and this is very important . . .unless the underwriter can show that “after reasonable investigation” (and that is the key language) it had reasonable grounds to believe that the disclosure document was accurate. That is the due diligence defense. Note that the words “due diligence” do not appear anywhere in the Securities Act of 1933. It is a phrase that has come to be used colloquially to refer to the process of fulfilling the statutorily created standard that if an underwriter believes the disclosure to be accurate and complete, then the underwriter has no liability, so long as that belief is arrived at “after reasonable investigation..” The “reasonable investigation” is the due diligence process. It is designed to make sure the underwriter has not stuck its head in the sand and merely accepted as gospel all that the issuer has written, but rather has conducted a “reasonable investigation” before accepting the disclosure document as complete. If, after a “reasonable investigation” there exists nonetheless a material misstatement or omission , the issuer is liable (recall the issuer has no defense) but the underwriter escapes liability. That is why the “reasonable investigation” process is known as the “due diligence” defense.

 

But this raises another question. What is a “reasonable” investigation? Put another way, how much due diligence is enough, how much investigation need be done to be found “reasonable” enough to invoke the “due diligence” defense?

 

We start with the standard of what constitutes “reasonable” investigation that is contained in Section 11 itself. It says that “the standard of reasonableness shall be that required of a prudent man in the management of his own property.” Congress gets no bonus points for guidance on this one.

 

Where Congress started, the courts and industry practice have filled in the landscape to some extent. Typically an underwriter engages a law firm to assist in the due diligence process. The law firm is assigned the task of conducting the “legal” due diligence. At a minimum, this is a review of all material and business documents contracts and agreements. Starting with the basic incorporation documents, the law firm will review loan documents, bank and other financing documents, contracts, leases and agreements material to the business, pension plans, compensation plans and benefits, insurance coverage, profit sharing arrangements, shareholder lists, union contracts, and internal corporate governance documents. In appropriate situations, title reports and environmental surveys may be requested for significant real property owned by the company. In today’s environment, Patriot Act and money laundering regulations may have a bearing on a company’s operations or ownership. The “legal” review is a key element of the due diligence process and an underwriter should have the greatest confidence in the law firm selected for this task.

 

A second level of analysis is the financial analysis. This is a thorough review and dissection of the issuer’s financial statements, books and records, including its tax returns. The outside accounting firm engaged by the company is debriefed, questioned and challenged, not in an adversarial manner, but to get an insight into the level of review or audit conducted by the outside accountant and an explanation of the various accounting principles relied upon to generate the financial presentation. Where alternate presentations are permissible, typically the underwriter will try to understand why the method chosen was found to be the better presentation. Included in this financial review should be a complete understanding of internal controls and accounting and bookkeeping practices. The underwriter should not hesitate to interview all levels of accounting personnel.

 

The third key element of a due diligence review is an understanding of the business of the company and the industry in which it operates. This is perhaps the most significant area of due diligence. For an underwriter to have fulfilled its due diligence obligations, it should be thoroughly familiar with the business of the company and its industry. There are three major components to this, a company’s products and services, its supply chain and its administration. As to the company products or services, the underwriter should be familiar with the manner the goods or services are produced, including manufacturing issues, as well as the marketing strategy, pricing and gross margins. This would include market share, a grasp of the total market and the strategy to capture part of that market. On the supply side, the underwriter should understand the strategy for sourcing raw materials, pricing and vulnerabilities. On the administration side, the underwriter ought to have a firm grasp on how the company is organized, in addition to understanding the organizational chart and lines of responsibility.

 

All of this is well and good, but how much is enough. The answer is – enough to be assured that the underwriter has a firm grasp on the business and affairs of the company that enables it to offer and sell securities with confidence that its customers have been fully apprised of the company’s legal, financial and business position The underwriter ought to take the Securities Act at face value and think,. “if this were my money, if my entire retirement and my family’s future, were invested in this company, what would I like to know?” If the underwriter can honestly say that it had done all it would have if that were the case, then . . . it will have done enough.