Raising the Bar: Private Placement Offering Subscriber Due Diligence Standards

Commercial real estate securities private placement offering subscription agreements are the potential source of future claims of investment fraud when an investment property fails to perform for a given reason.  The rising burden of due diligence compliance with FINRA and the SEC have to be viewed as reactive measures which provide little solace in the way of prevention of future claims.  Investors claiming investment fraud as a result of an investment failure have turned into a financial crisis that has fueled a rising tide of litigation and loss exposure for investors, sponsors, broker-dealers, lenders, and registered investment advisors.  This flood of misery has created a huge burden on the CRE finance industry that has dramatically increased operating expenses without increasing revenues.  It’s time to raise the bar on subscriber due diligence and switch to a proactive approach to managing future investment fraud claims loss risk exposure for the benefit of all of the participants in the capital markets.

Prevention requires action that is proactive so that you help prevent it and not be left to pay the bill for cleaning up the mess years after the fact.  First, we have to recognize the nature of the problem so that solutions can be contrived that have an actual chance of working on a systemic basis.  The causal factors for investment fraud claims originating from investors can be grouped into the following key problem areas:

  • Risk Disclosure.  The investor was defrauded by the issuer because the issuer did not disclose a given risk that was the cause of the investment failure.
  • Insufficient Due Diligence. The investor was defrauded by the issuer because the issuer did not exercise sufficient due diligence regarding the future business prospects of the issuer that was the cause of the investment failure.
  • Promoter Acts.  The investor was defrauded by the issuer because the issuer acted with gross negligence or with criminal conduct and these actions were the cause of the investment failure.

Risk disclosure requires a two (2) prong approach: (1) complete disclosure; and (2) subscribers acknowledging their understanding of the risks disclosed.  The practical solutions are:

  • Due diligence is not treated as a one-time act that is undertaken prior to the close of escrow, but an ongoing initiative that not only discloses potential future risk events that may impact the investment, but also recognizes future market opportunities that may create better than expected outcomes.
  • Acknowledgement of the resulting risks requires the sponsor, B-D and/or RIA to conduct pre-investment interviews to provide affirmative evidence the subscriber has read the offering memorandum, understands the due diligence process and results that were provided, understands the nature of the risks involved, has decided the potential economic returns justify their investment of at-risk capital in spite of the risks involved, and has received satisfactory answers to all requests for information and questions the subscriber has had prior to making a final decision regarding the subscriber’s desire to invest money.

Claims regarding insufficient due diligence are borne out of unpredictable future outcomes – we have to realize it is simple as that and also the source of the solution.  Insufficient due diligence becomes sufficient when reasonable care is demonstrated that investment due diligence is conducted on an ongoing basis after the date of funding.  Investment performance assurance monitoring is now a fact of life and those who choose to ignore the benefit will likely be made to suffer.  Suffering will not just be more investment fraud claims in the future, but loss of opportunity due to the nature of our evolving market economy that creates business investment opportunities.

Similarly, the due diligence issue can also help resolve the bad actor issue.  Independent monitoring of ongoing operations and management decisions provides a solid basis for early detection of management incompetence (completely fixable) and limit the damage of criminal acts (and most criminal acts would be insurable events).

Raising the bar on subscriber due diligence is not a new fad, but may become a fact of life for those seeking to create future business opportunities.


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