In performing due diligence on securities offerings, broker dealers must examine numerous criteria. The goal is not only to provide an adequate investigation, but also to match the offering with the right investor. Not every solid security will be right for every investor.
It is not simply enough to ensure that the issuer has a strong financial base or that the security being offered is sound. The broker dealer must also consider the investor they are pairing with the security offering. This suitability requirement is established in Rule 2111. According to this requirement, the broker dealer must believe that their recommendation is suitable for that particular customer.
Meeting the Suitability Requirement
The broker dealer must believe, after adequate research, that the recommendation they are making in regards to a security offering is well-suited to that customer based on the customer’s goals, investment experience and tolerance to risk.
Another criterion to meeting the suitability requirement involves the number of transactions the broker dealer has recommended during a specific period. The number cannot be excessive as compared to would be considered normal for this type of customer.
The most basic of the criteria for suitability relates to the due diligence investigation of the security and the issuer. This is known as reasonable basis suitability and is the basis of the broker dealer’s investigation into securities being offered.
Dealing with Experienced Customers
According to Notice 10-22, the broker dealer must still meet the obligation of a reasonable investigation, even if the customer is knowledgeable about investing in general or about the security offering in particular. On the other hand, the scope of the investigation should be more stringent when a customer is not an experienced investor or is a retail customer with limited knowledge. In other words, it would be expected that the broker dealer would spend more time evaluating an offering for sale to a novice customer than for one who has been investing regularly for years.
While each investigation is designed for a particular Regulation D offering, it is important to follow a list of best practices to ensure that all essential items and steps are covered. This enables the broker dealer to be confident that they are meeting the obligations of a reasonable investigation for the offering.