Due Diligence by Dummies

Due diligence is one of the most misunderstood concepts in the financial world.

As an attorney, I have examined and cross-examined quite a few due diligence officers and experts employed by FINRA brokerage firms. Even those people who are specially tasked with the job of conducting due diligence investigations often do not know what they are doing or why.

The why is easy. Lawyers and underwriters who prepare securities offerings are required to include all the material facts in the offering documents. To do it properly, the lawyers and underwriters must independently investigate the facts to make certain that the sales materials given to potential investors are accurate, complete and the sales pitch for the security is honest.

The law does not presume that the management of any business will necessarily tell their lawyers or underwriters the whole truth. Management, especially management that is in the process of raising money, will often emphasize the positives about the business and leave the negatives out entirely. A good due diligence investigation is always infused with a healthy amount of skepticism about the managements’ claims for the business.

The large Wall Street investment banks usually do a pretty good job of due diligence. The bankers and lawyers usually charge the issuers at Wall Street billing rates to get the investigation done as part of the underwriting process. They frequently bring in experts with unique knowledge of the industry that the business is in.

A good due diligence investigation is the best way for these bankers and lawyers to protect themselves against investors’ claims of misstatements or omissions in the offering documents down the road. For securities lawyers, a good due diligence investigation is their insurance carrier’s best friend.

The due diligence team needs to have a sense of the business that they are investigating. They need to understand the cash flow, the real risks facing the business and how its competitors are positioned.

Even the best sometimes make mistakes. Those who really do not understand the process and those who focus on cutting costs make mistakes more often. Billions of dollars in offerings for Ponzi schemes that were sold by FINRA firms would not have made it to the market if the FINRA firms conducted real investigations of the facts they were presenting to their customers.

Here are some examples of poor due diligence from actual cases:

1) A few years back one of the larger Wall Street firms raised $60 million for a real estate developer who was planning to build a new high-end residential community in Southern California. The carefully calculated projections that came with the offering documents promised that 300 homes could be built and sold in the first year. Only after the money was raised was it discovered that the County in which the development was located, which had been through several years of drought, was not authorizing that many new residential water hook-ups.

2) In a case where a single office building was being syndicated to investors, no one bothered to have the building inspected by a professional building inspector. If they would have done so, they probably would have discovered that the roof of the building leaked, and leaked badly. Most prudent people would not purchase a home without an inspection. Many lenders insist upon it. The brokerage firm executives, some of whom had partied on the promoter’s yacht, apparently did not think that an inspection was necessary.

3) A prospectus will frequently describe the people behind the company as “successful”. Investors value prior success and many people who are raising money claim that they were successful in prior ventures. One real estate developer was described as successful even though he had put his only prior development into bankruptcy. I have asked a lot of due diligence officers to produce their files on an executive’s participation in the success of prior ventures. Very few could produce one.

4) For example, one real estate promoter who raised hundreds of millions of dollars in Reg. D offerings through FINRA firms was described in the prospectus as having previously been the owner of a successful financial firm. Due diligence officers at each of the FINRA firms that sold the offerings failed to discover that the SEC had determined that the financial firm was actually owned by someone else and that the promoter had lied to the SEC when they asked him about it. The SEC case was a matter of public record.

5) Banks frequently use their own appraisers when making a loan because they are risking their own money. A brokerage firm that is risking only investors’ money will often accept the appraisal that the promoter provides. That is never prudent, nor diligent.

I have seen two appraisals that were issued by the same appraiser on the same day for the same property. The one that went to the brokerage firms estimated that the property was worth 5% more than the amount they gave to the bank. Giving a false appraisal to a bank is a felony which is often prosecuted. Giving a false appraisal to a brokerage firm’s due diligence officer is not. Underwriters need to get appraisals from appraisers that they trust and who they pay for, even if ultimately reimbursed by the issuer for the cost.

6) Several large and respected VC funds and investment banks invested funds to build a $500 million processing plant for a company that claimed to have a new process to produce ethanol from wood scraps. The company claimed that the process was proprietary and ready to go which was why they were seeking funds for construction of a large plant to begin producing ethanol. After the bankruptcy, it was determined that the process did not actually work and had never been patented. None of the firms hired a chemical engineer to review the patents or the process. They saved $5000 by not doing so and wrote –off over $500 million because they did not.

7) An offering for a franchised hotel stated that its occupancy would be largely dependent upon events at a new arena being built just across the freeway. The projections indicated that the arena had sporting events, concerts and other events scheduled 340 days a year. A call to the arena box office confirmed that the arena was largely dark for its first few years of operation and was never projected to be occupied 340 days a year. Had a due diligence officer made the same call at the time the securities were being offered and the correct projections given to investors, there probably would not have been any litigation.

8) The SEC just recently brought actions against 22 banks and brokerage firms for failing to conduct adequate due diligence investigations on municipal bond offerings. You can almost hear the due diligence officers saying: “it is a municipality, why spend the time and money investigating it?”

Economic problems are sometimes best viewed along the margins of the markets. The new crowdfunding industry is certainly on the margin of the capital markets. Although each funding project is relatively small, no one doubts that hundreds of billions of dollars will be raised on these platforms as time goes on. Investors on these platforms are entitled to the same honest disclosures of material facts as are any other investors.

At the same time, because the offerings are small, the crowdfunding industry has loudly denounced the need for audited financial information because of the added expense. The probable result will be a great many small companies who will claim solvency when they are not and who will use investors’ funds to pay off undisclosed debts rather than expanding their business as promised.

The SEC always tells investors to investigate before they invest. Underwriters, attorneys and crowdfunding platforms are equally charged to investigate before they offer securities to the public. It is just common sense.

FINRA Arbitration – How investors actually fare

Arbitration is arguably the most efficient way for public customers to resolve a dispute that they may have with their stockbroker. I have personally been a participant in a great many more securities industry arbitrations than most people.

But the arbitrations themselves have become suspect. Too many customers who have clearly been defrauded by their stockbrokers are walking away uncompensated and shaking their heads. A brief case study will illustrate the point.

I located only 35 awards in the FINRA Arbitration Awards database concerning securities issued by a company called DBSI. DBSI was a national real estate syndicator that filed for bankruptcy protection in 2008 and was shown to have been operating as a Ponzi scheme.

I chose DBSI claims for three reasons:

First, the Examiner working for the DBSI’s Bankruptcy Trustee filed a comprehensive report detailing how DBSI had operated as a Ponzi scheme from at least 2004 at which time DBSI was already insolvent. Like any classic Ponzi scheme, DBSI was using funds collected from new investors to pay obligations to prior investors.

Second, virtually every private placement offering that DBSI made after 2004 (approx. $800 million in total) contained an un-audited balance sheet that stated, falsely, that the company was actually solvent. This was important because with each offering the company was taking on financial obligations to the investors, mostly lease payments for the buildings that it was syndicating.

Third, brokerage industry standards require the firms that sell private placements to verify the information that they are handing out in the private placement memorandums s (PPMs). Verifying DBSI’s claim that it was solvent when it was not would not have been possible. Logic and experience suggest that the approximately 100 brokerage firms that sold DBSI securities failed to conduct a reasonable due diligence investigation if they conducted any investigation at all.

So, we have an independent report filed with the Bankruptcy Court that would seem to establish that investors were given false financial information about DBSI at the time the brokerage firms sold the DBSI securities to them. The principal of DBSI was also convicted of fraud, on basically the same facts, at his criminal trial.

We also have aggrieved investors who begin the FINRA arbitration process knowing that the investment that their stockbroker had sold to them was a Ponzi scheme. The public investors should have a reasonable expectation that a securities industry arbitration panel would find that selling interests in a Ponzi scheme to be beneath industry standards and be willing to award the investors adequate compensation.

So how did the complaining investors actually fare?

Of the 35 awards involving DBSI securities that I could locate in the FINRA Arbitration Awards database, the results were as follows:

In 8 of those claims the brokerage firm had either filed for bankruptcy protection or defaulted and failed to appear at the hearing. In two of these claims the brokerage firm was not a named party presumably because it had gone out of business. A substantial number of the brokerage firms that sold DBSI securities did exactly that. Had they not, I would think that there would have been a lot more claims.

The arbitrators made awards in several of these “defaulted” claims where the customers were able to prove up their claim and establish their damages. There is no indication that the defaulting firms actually paid anything to these customers. A brokerage firm that will not defend a claim will generally not pay the award.

In FINRA statistics these count as a win for investors because an award was made, even though the customers did not actually receive compensation for their losses. FINRA does not require its member firms who sell these private placements to have either adequate net capital or adequate insurance. FINRA does not take any steps to enforce an award against the principals of a firm who sell Ponzi schemes and then close up shop.

In 10 of the 15 claims where the brokerage firm was present and represented by counsel the arbitrators dismissed the claim or awarded the investors nothing. One has to wonder why these 10 panels of arbitrators could not be convinced that selling a Ponzi scheme to public customers was conduct for which the customers should be compensated.

In the 5 fully adjudicated claims where the arbitrators did make an award in the customers’ favor, in only one did the panel order the offending DBSI investment rescinded and the customers fully compensated. The rest of the awards were for much less than the amount that the firms’ customers had invested.

In one of the adjudicated claims the panel dismissed the claim for one DBSI investment and made a small award on a second. Both of these offerings contained fraudulent financial information about DBSI. What could these arbitrators have been thinking?

Twelve of the claims brought by customers seeking compensation for DBSI losses were settled for undisclosed amounts. Pre-hearing settlements are often based upon each party’s evaluation of what might be their worst result if the claim is given to the arbitrators to decide. The fact that only one panel deemed it appropriate to rescind the DBSI transactions and fully compensate the customers would certainly impact the brokerage firms’ idea of what might be the worst result that they might suffer if they did not settle.

When you boil this down to the fact that in only one claim in 35 did the customer get all or a substantial award from the FINRA arbitration panel when all were clearly defrauded, it does give one pause to consider than something may just not be right.

Perhaps it might help to look at the expungement phase of some of these hearings. Claims like these are routinely expunged from the record of the individual registered representatives when the claims settle.

After a settlement, the arbitrators conduct a live or telephonic hearing to determine if the claim should be wiped from the representative’s record. The claimants and their representatives do not usually appear at this hearing, nor should they need to appear. Left alone with the arbitrators some industry firms may be taking advantage.

In more than one claim the expungement order noted that the claim (for selling a Ponzi scheme to a public customer) was factually impossible. In others, the panel held that the offering materials (which contained fraudulent financial information) were within industry standards or that the due diligence (which, if done correctly could not have verified that DBSI was solvent as it claimed to be) was adequate and also within industry standards. I personally refuse to believe that industry standards have fallen that low.

These findings by the panels are often supported by “experts” whom the brokerage firms bring to the expungement hearings to educate the panels without cross-examination. If an arbitrator hears this recitation of “industry standards” from an expert or two provided by the industry over several cases, many apparently start to believe it.

It is certainly logical to assume that after many claims involving DBSI and several other large Ponzi schemes that were sold to public customers in the last market cycle (Medical Capital, Provident Royalties, etc.) the arbitrator pool around the country may have been tainted by the patently false “opinions” of these industry “experts”. Arbitrators get no training in securities law or industry standards from FINRA.

Securities industry arbitration has always been considered to be efficient because it costs less than state court litigation. The cost of the forum should be irrelevant if the customers cannot realistically expect to obtain a reasonable recovery of their losses in cases like this. I cannot fathom that a series of 35 juries sitting in civil courts around the country would come up this many defense victories. If I am right then clearly there must be some defect in the FINRA arbitration system.

As importantly, the lack of compensation awarded to these aggrieved investors in FINRA arbitration forums re-enforces a business model where a broker/dealer can be inadequately funded, carry no insurance, affirmatively flaunt the rules, conduct inadequate due diligence and sell millions of dollars of fraudulent investments to thousands of investors. Once exposed, the principals can simply close up shop and open up across the street under a new broker/ dealer and start over.

Either way, if FINRA intends to advocate its forum as fair and equitable to the public investors, it should take steps to see that it really is.