One of the tasks of a broker dealer in a due diligence investigation is to find any red flags for either the issuer or the security offering. Overlooking these red flags could be detrimental to the broker dealer if the offering should fail.

The Importance of a Red Flag to a Broker Dealer

According to Notice 10-22, a “red flag” is any information that would alert the broker dealer that they should conduct an additional inquiry or hire independent due diligence experts to evaluate the issuer and the offering. A red flag can also be considered to be any adverse information that may have significant impact on the validity of an offering.

When a broker dealer ignores information that could be labeled as a red flag, or is negligent in unearthing such red flags, it places them at risk for violating FINRA regulations governing due diligence investigations. It is important to consider how to handle red flags, but first one must recognize those most commonly seen.

Red Flags Commonly Seen in Security Offerings

If the issuer fails to provide any information requested in a due diligence review, it should be considered a red flag. If they are not responsive when the broker dealer requests documentation, the broker dealer must find the data elsewhere or determine if they have sufficient information with what is available.

While preparing a PPM is not always required, it has become market practice in most scenarios. Therefore, not preparing one can be a red flag for the broker dealer to follow up on.

Apparent financial issues should always be seen as red flags, including problems meeting payments, liquidity issues and defaults on loans or other financial obligations. Inaccuracies in the PPM or other documents can also be seen as a red flag. Sometimes, a third-party review will reveal potential issues even if they had not been discovered by the broker dealer. It is the broker dealer’s obligation to then follow up on any of these concerns that have been brought to their attention.

How a Broker Should Handle Red Flags

When information is presented that raises a red flag to the broker dealer, they have an obligation to investigate further. They must either allay their concerns or find further information to support the issues being raised.

The broker dealer must go beyond information presented by the issuer when a red flag is raised. They cannot rely on a disclosure in the PPM or in any reports or audits from the issuer. Instead, the broker dealer should look at independent information to enable them to move past the area of concern. They may even contact a third party due diligence expert to gain a new perspective of specific information.

It is the responsibility of the broker dealer to review all information and determine if any red flags are present. In addition, they must either resolve the concerns or determine that the security offering should not be recommended. If a broker dealer fails to address these issues, they could be penalized for inadequate due diligence and fined or even suspended if the violation is serious enough.
You can contact a PPM Lawyer if you want more help.