Due Diligence Does Not End at the Signing of the Selling Agreement

by Kemp H. Hanley

I’ve always been a big proponent of ongoing due diligence coverage on direct participation programs. Back when I was an assistant portfolio manager for a large mutual fund company, our coverage of a company certainly didn’t stop after the buy trade was processed. Later, as a product sponsor in the independent broker-dealer channel, I was struck by the disinterest in our selling syndicate once the selling agreement was executed.

Now I’ll admit that this was more than a little while ago. I’m glad to see that the industry has evolved since I was a sponsor of direct participation programs. Today, ongoing due diligence coverage on open programs is much more customary, due in large part by ever-evolving regulations and increased awareness in the industry. Also helpful is that third-party due diligence firms (such as FactRight and others) have honed their ability to collect relevant data on an ongoing basis and present it in a concise and digestible manner.

Let’s look at why ongoing due diligence is imperative from a regulatory standpoint, and then we’ll drive the point home with some real-life examples of how we’ve protected clients and investors by uncovering problems with programs on their platforms.

The regulatory imperative of ongoing coverage

Court records are littered with cases against broker-dealers and RIAs allegedly lacking appropriate due diligence as required by securities regulators. First, let’s look at the specific regulatory mandates about due diligence of alternative investments and complex products.

The following requirements and guidance focus primarily on initial due diligence or recommendation of a product. However, they also have bearing on situations that may compromise or impact subsequent recommendations to clients, which is what makes ongoing due diligence necessary.

SEC Regulation Best Interest:

  • One must exercise reasonable diligence, care, and skill when making a recommendation to a retail customer.

FINRA NTM 03-71:

  • Members must perform appropriate due diligence to ensure that they understand the nature of the product as well as the potential risks and rewards associated with the product.

FINRA RN 12-03:

  • Registered representatives who recommend complex products must understand the features and risks associated with those products. 
  • Regulators have expressed concern about complex products because the complexity of these products can weaken the ability of registered representatives or their customers to understand how the product will perform in a variety of time periods and market environments.


  • In the context of a program with a significant shelf life, where material events can occur after a selling agreement is signed, ongoing due diligence is critical to determining whether a program should remain on a platform and be available for clients.
  • Technically, every distribution reinvested into shares of an issuer (through a “DRIP”) is a new investment. Thus, ongoing monitoring of a program is necessary to determine whether participating in a DRIP for that program is appropriate for clients.
  • Current assessment of a program may also be important for recommending whether clients should avail themselves of any limited liquidity feature.

The practical importance of ongoing coverage

Keeping investors out of trouble is paramount for regulatory and business reasons. In today’s pandemic environment, investment advisors must be knowledgeable about management’s efforts to adapt to market changes, potential changes in sponsor management or program structure, and how a program may be performing in aggregate and against peers. The following brief case studies from FactRight highlight the importance of ongoing research.

Case Study #1

While analyzing general and administrative expenses as a percentage of revenue for a nontraded REIT program, a FactRight analyst noted a high ratio compared to the program’s sector peers. Further digging to determine if the anomaly was temporary found that management had amended its advisory agreement within months of its initial offering in order to make the REIT responsible for expenses initially disclosed as sponsor expenses. These amendments materially changed the structure of the program. Simply relying on an assessment of the documents upon launch of the offering would not have uncovered this event.

Case Study #2

After conducting ongoing distribution sustainability analysis for a perpetual life program, we informed clients in certain selling syndicates of two issues: eroding distribution coverage and the prospect of future distribution reductions and or declines in net asset value. This conversation contributed to several investment committees deciding to suspend offering the respective programs.

Case Study #3

In light of certain events and underperformance in a strong real estate market, we recommended that clients vote against actions recommended by the board of directors in some proxy solicitations and to vote against the election of incumbent directors at certain REITs. 

Ongoing coverage made easy

Regulators have made it clear that program due diligence should not stop once a selling agreement has been executed, and I am heartened by the evolution of the industry. Today, more and more broker-dealers and RIAs are looking to third-party due diligence providers to help with ongoing coverage of the programs on their platforms. And as illustrated above, I have also witnessed the direct benefits obtained by broker-dealers and RIAs who utilize third-party providers to cover investment programs on an ongoing basis. FactRight has the bandwidth and analytical tools to assist broker-dealers and RIAs who meet their regulatory and fiduciary obligations yet do not have the internal capability necessary for best practices.

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