Due diligence was originally a judicial construct that provided a defense for underwriters who were jointly and severally liable for fraud perpetrated by the companies they brought to market. If the underwriter could not have discovered the fraud after a diligent investigation of the issuer, then the courts reasoned that there was not much more that the underwriter could do.

The due diligence investigation fell to the lead underwriter who was well paid for its efforts and upon whom other members of the selling group could rely. The underwriter’s due diligence investigators would consult with the issuer’s attorneys and accountants, pour over legal documents, ledgers and spreadsheets and visit factories, properties and sales offices. A good due diligence investigation included a look at the company’s customers, suppliers and competition, as well.

Due diligence has been a staple for underwriters for more than 40 years. The SEC has acknowledged the process in its new crowdfunding rules. Every legitimate brokerage firm underwriting new issues of securities employs some kind of acceptable due diligence process with one glaring exception: firms that underwrite Reg. D offerings sold to retail accredited investors. .

FINRA has codified the requirement of a diligent investigation by member firms selling private placements under Reg. D. The FINRA standard is specific; the member firm should verify the facts that are being given to investors. In a great many cases, a diligent investigation just does not happen.

When Reg. D was enacted, in the early 1980s, the vast majority of private placements were purchased by large institutional investors. These firms had the ability to review and analyze the offerings by themselves. Institutional purchasers would send their own lawyers and accountants to the issuing company before they sent their money.

Reg. D allowed wealthy individuals to invest in private placements as well. The rule set the threshold for “wealthy” investors at above a $1 million net worth. Wealthy individuals, it was reasoned could afford to sustain the losses if they occurred. Reg. D calls these wealthy individuals accredited investors. At the time there were fewer than 1 million millionaires in the US. Today there are 10s of millions.

A due diligence investigation of a company seeking to raise capital from investors is not difficult. My partner and I conduct due diligence investigations for VC funds, angel investors, family offices and broker/dealers. Individual investors, unless they are making a large investment, rarely call us.

The SEC estimates that $800 billion dollars worth of private placements are now sold every year, a very significant the vast majority of the funds coming from individual accredited investors. Experience has shown that some brokerage firms, including those that sell billions of dollars of private placements to individual accredited investors, do not diligently investigate the offerings that they sell. Hundreds of billions of dollars in investor losses are directly attributable to that fact.

After the credit market crash in 2008, many companies that had used Reg. D to raise billions of dollars were shown have been frauds. More than a few were Ponzi schemes. The latter, in many cases, were facades that had no business, just a good story about how investors were going to get paid high returns.

In some cases, more than 100 FINRA broker/dealers signed on to raise money for these Ponzi schemes. If they had done any investigation of these companies, they would have seen that the represented business did not exist. Selling a Ponzi scheme is usually a prima facie example of a firm that did not conduct a diligent investigation and probably conducted no investigation at all.

FINRA, the SEC and the state regulators did not impose significant penalties against firms that sold Ponzi schemes to investors. Civil recoveries by investors against the brokerage firms that sold the Ponzi schemes have been negligible. There is nothing in the market to incentivize a brokerage firm to conduct a real due diligence investigation; nor anything detrimental if they fail to do so.

The Dodd-Frank Act requires the SEC to re-consider the threshold for accredited investors every four years. If the SEC raised the threshold for net worth to $5 million, it would simply be an adjustment for inflation during the 30 plus years since the $1 million figure was set. It would also reduce the number of potential investors and the amount of capital that is available to this market.

The SEC seems intent upon expanding the amount of capital available to this market rather than contracting it. The Commission has already approved a change to Reg. D that makes it easier for firms to solicit potential Reg. D investors. No new protections for individual accredited investors seem to be forthcoming.

Many real estate and energy companies are serial issuers; they fund project after project using Reg. D. You can spot these professional sponsors at meetings and conferences where they wine and dine brokerage firm executives to get their offerings noticed and sold.

Brokerage firms will continue to give lip service to due diligence investigations but not perform them diligently. Ponzi schemes and other fraudulent offerings will continue to be sold to investors under Reg. D. Individual accredited investors will continue to bear the brunt of the losses.

Some things about the future of markets are easier to predict than others.