Advisor Due Diligence
The growing demand for alternative investments stems from increased investor appetite for high returns and diversification and the fact that the barriers that kept smaller investors away from these products have diminished in recent years. As an advisor, you can help yourself avoid regulatory pitfalls by working with a qualified custodian, and by educating yourself and staying current with current SEC Rules and FINRA Guidelines.
Know what you are selling
FINRA guidance should generally be closely adapted by financial advisors as a best practice policy to ensure that the client’s best interests are being met. At a minimum, advisors should understand products before offering them to clients, conduct due diligence and ensure the suitability of client participation.
Use these starting points. Pay particularly close attention to the new Suitability Rule (FINRA Rule 2111) which imposes broader obligations on advisors regarding product and strategy recommendations, even on suggestions to “hold” a security. Another good document to download and read is Know-Your-Customer Rule (FINRA 2090) and SEC Custody Rule 206(4)-2, which states that client funds and securities must be maintained by a qualified custodian.
Expand your knowledge of due diligence obligations with FINRA Regulatory Notice 09-09, which reminds advisors and broker-dealers of their ongoing responsibilities to communicate critical investment events to clients, as well as consider how distributions could be impacted. For example, an advisor should keep a client up-to-date on unscheduled cancellations of existing leases that could impair or materially affect a real estate investment program’s cash flow.
Research the issuer FINRA Regulatory Notice 10-22 states that advisors should conduct a reasonable investigation concerning the issuer and its management, the business prospects of the issuer, the assets held by or to be acquired by the issuer, the claims being made and the intended use of the proceeds of the offering.
Look for caution signs Advisors should be particularly watchful for red flags. These include a working knowledge of an issuer’s financial position and whether they’re providing unaudited or audited returns; willingness of an issuer to divulge information; criminal and regulatory events of principals of the issuer; poor past performance of previous offerings; any pending litigation; and the use of unsubstantiated financial models to generate projections or targeted returns.
Be a detective Go to www.sec.gov to see if your alternative asset candidate has any enforcement cases on the SEC website before making a major asset deployment to an unfamiliar alternative product.
Catch up on JOBS Act implications The JOBS Act is slated to create a whole different category of alternative investments beginning in 2013; the threshold for qualifying as an accredited investor will be lowered as well.
Examine platforms carefully Advisors should also select alternative investment platforms only after examining their structure to ensure they have a clear separation of duties among the trading partner, prime broker and other service providers.
Other regulatory resources to explore include the Financial Services Institute
and the National Society of Compliance Professionals
IRS rules and regulations concerning IRAs and Alternative Investments can be found at IRS.gov: