Inadequate Due Diligence and SEC Enforcement: Investigation Focus Areas
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Inadequate Due Diligence and SEC Enforcement: Investigation Focus Areas
The Securities and Exchange Commission (SEC) takes due diligence failures very seriously. When companies don’t do enough research on investments or business partners, it can lead to big problems down the road. Lately, the SEC has been cracking down on inadequate due diligence through its enforcement actions.
What exactly is due diligence? It’s basically doing your homework before making a big decision. For example, if a company wants to acquire another company, it should research that company’s finances, operations, legal issues, etc. Thorough due diligence helps avoid nasty surprises.
The SEC says due diligence lapses have become way too common. Some of the biggest investigation targets recently include private equity firms, investment advisers, broker-dealers, and special purpose acquisition companies (SPACs).
Private Equity Firms
Private equity firms pool money from investors to buy companies or assets. They’re required to be transparent about all the fees they charge. But sometimes private equity firms fail to disclose fees paid to affiliated companies they own. The SEC considers this a due diligence failure.
For example, in September 2022 the SEC charged Prime Group for not adequately disclosing fees. Prime Group didn’t tell investors about a $20 million monitoring fee paid to a Prime Group affiliate. The SEC said Prime Group skipped important due diligence steps, resulting in faulty disclosures. Prime Group paid a $20.5 million fine to settle the charges.
The SEC crackdown aims to stop private equity advisors from engaging in deceptive practices. Firms must have diligence procedures to ensure all required information is reported to investors.
Investment Advisers
The SEC also closely examines investment advisers’ due diligence efforts. Advisers must thoroughly vet any investments they recommend to clients. Recently, the SEC penalized several advisers for doing sloppy due diligence.
In November 2018, the SEC charged advisory firm GPB Capital with failing to properly evaluate securities before recommending them. GPB advisors put over 17,000 clients into high-risk private placements without doing adequate diligence. GPB agreed to pay a $100,000 fine.
Proper due diligence helps advisers avoid suggesting bad investments. The SEC is adamant that advisors must have diligence procedures and follow them consistently.
Broker-Dealers
Broker-dealers also face SEC penalties for lax due diligence. These firms buy and sell securities on behalf of customers. Broker-dealers must vet securities before offering them for sale.
In 2015, the SEC fined brokerage firm Edward Jones $20 million for inadequate due diligence on municipal bonds. The firm failed to review risk disclosures on bond offerings before selling them to customers. This exposed investors to greater risks than they realized.
The SEC is adamant that broker-dealers must have written diligence policies and implement them fully. Firms can’t take shortcuts that could harm investors.
SPACs
SPACs, or blank check companies, are a hot new area of SEC scrutiny. SPACs raise money through IPOs to acquire private companies and take them public. The SEC says some SPACs are severely lacking in due diligence.
In July 2021, the SEC charged SPAC Stable Road with shoddy due diligence before acquiring space startup Momentus. Stable Road failed to uncover that Momentus lied about its technology. This led to false claims in SEC filings. Stable Road agreed to pay a $7 million penalty.
With SPACs surging in popularity, the SEC is focused on improving due diligence and disclosure practices. SPACs must deeply investigate targets and provide accurate information to investors.
Common Due Diligence Lapses
When examining due diligence, SEC investigators look for these red flags:
- No written due diligence policies and procedures
- Due diligence conducted by unqualified personnel
- Using only limited information sources
- Failing to verify information independently
- Not retaining diligence records
- Ignoring or hiding negative findings
Firms that exhibit these deficiencies face steep SEC fines and sanctions. The SEC might also force improvements to diligence practices and disclosures.
Best Practices for Due Diligence
Here are some tips for making sure your due diligence meets SEC expectations:
- Establish comprehensive written diligence procedures
- Assign diligence to qualified professionals
- Use diverse, reliable information sources
- Independently verify all findings
- Maintain diligence files with audit trails
- Objectively analyze results, including negatives
- Fully disclose diligence results as required
Cutting corners on due diligence is asking for SEC trouble. But following diligent practices helps ensure you meet legal duties and serve investors.
Looking Ahead
The SEC will continue scrutinizing due diligence across the financial sector. Tougher enforcement is likely as new issues emerge. For example, the SEC is concerned about diligence on crypto assets and environmental disclosures. Proactive companies will beef up diligence now before the SEC comes knocking.
With the right due diligence culture and procedures, firms can avoid enforcement actions. But inadequate due diligence programs expose companies to legal violations, fines, and reputational damage. In the SEC’s view, due diligence should never be an afterthought.