The mission of The IRS is to provide investors institutional-caliber due-diligence for privately marketed investments, reducing the risk of making an investment decision that is based on inaccurate or misleading information.
By the end of Due Diligence 101, you’ll:
Accredited investors are assumed by the SEC to “have sufficient knowledge and experience in financial and business matters to evaluate the merits and risks of the prospective investment.” When it comes to non-registered investments, accredited investors are viewed as “financially sophisticated and able to fend for themselves or sustain the risk of loss, thus rendering unnecessary the protections that come from a registered offering.”
Source: U.S. Securities and Exchange Commission (investor.gov)
For any investment, be sure to ask questions about the following areas:
Keep in mind that sharp-looking companies with trustworthy facades are utilized by con-men to inspire trust in their victims. Temporary office spaces, welcoming receptionists, professionally designed brochures and impressive web sites, are all means used to create the illusion of legitimacy.
There are also “SOFT” and “HARD” forms of Due Diligence when it comes to Alternative Investments. Traditionally, analysts would perform Due Diligence by studying the market, structures, costs, liabilities, assets, etc. This step is known as HARD Due Diligence. Recently, more deals have also been the subject to the study of the company’s management, culture, as well as other human elements – this side of things is known as SOFT Due Diligence. The rationale why both methods are essential is because HARD Diligence is susceptible to interpretation by salespeople, which is when SOFT Due Diligence comes in, acting as a counterbalance.
Getting to know your subject is essential before entering into an investment. Even if an investment offering looks exceptionally encouraging, neglecting to do a background check of the company’s management and operations can end up the reason the investment fails. While a deal might seem able to generate long-term value, the company in question could still fail as a result of structural inefficiencies or management with a history of failing to scale a business successfully.
Pick up the phone: If an investment representative says they work with a specific party or service provider, do not just confirm the relationship but try to have a conversation with the other party. It is often very informative and provides a different perspective than your contact will give you.
It is rare that the claims in an offering are 100% verifiable. In addition to raising red flags, Due Diligence helps you know which areas are verifiable and which aren’t so that you can incorporate that knowledge into your overall risk assessment.
Risk Tolerance Varies from Investor to Investor.
Risk Awareness Should Not.
In the next section, we’ll provide you with a detailed checklist to guide you in performing quality due diligence in the areas above.
Due-Diligence is hard work, so we’ve prepared a due diligence checklist to give you a clear roadmap while performing your due diligence.
Your due diligence should gather information about:
Your due diligence should gather information about:
Your due diligence should gather information about:
Your due diligence should gather information about:
Description of the competitive landscape within each market segment including:
Your due diligence should gather information about:
Your due diligence should gather information about:
Salesforce productivity model
Your due diligence should gather information about:
Description of the R&D organization:
Your due diligence should gather information about:
Your due diligence should gather information about:
Download due diligence checklist
Red Flag #1: Be alert for anyone who is reluctant to share information
Issuers and their Broker-Dealer agents should ensure all the data in the checklist above is easily accessible so that the investor can efficiently make an informed investment decision.
Anyone not prepared to discuss the details of their business, even when under the shelter of a Non-Disclosure Agreement that an Investor may be willing to sign, should be approached with great caution.
While the emphasis during a due diligence analysis will be targeted to specific areas of a potential investment, areas that may initially seem less important may ultimately have a significantly detrimental impact on the offering if not appropriately addressed.
Know your limits: Due diligence (particularly on operational issues such as legal, compliance, valuation, IT, etc.) frequently demands specialized knowledge which many investors may not possess. In these circumstances, you should not be reluctant to work with experts that have specialized knowledge.
In the next section, we’ll teach you about the free tools and resources at your disposal as you perform your own due diligence.
Now that you know what to look for when performing your due diligence, how do you begin?
Look through the list and start thinking about the filing with the information you’re searching for. When examining whether a company may be a potential buyer, what you want to know is how important the target’s industry is to the possible bidder. Getting the full details on the importance of an industry to a company is exactly the type of thing a 10-K is for.
If you are looking for a broker or brokerage firm:
Simply perform BrokerCheck search after accepting the FINRA BrokerCheck Terms & Conditions. Once you perform a search, you can view a report summary on a brokerage firm or broker. You then have the option to download, print, or click through a complete report about a firm or broker’s background. The BrokerCheck report reflects information that FINRA requires brokers, brokerage firms, and regulators to report as part of the securities industry’s registration and licensing process.
If you are looking for an investment adviser firm or representative:
Perform a BrokerCheck search after accepting the FINRA BrokerCheck Terms and Conditions. Once you perform a search, click on the “Investment Adviser Firm” or “Investment Adviser Rep” link to open a new window for the Securities and Exchange Commission’s “Investement Adviser Public Disclosure database. After completing the authentication page, you can view the available information for the investment adviser firm or representative.
Additional Tools
AS OF FEBRUARY 28, 2019, individuals on this list have a FINRA bar in effect. They are prohibited from engaging in securities or investment banking activity. For more information about a listed individual, click the individual’s CRD number. You can also learn more about FINRA bars, including when they are posted to this list and when a sanction is subject to review and modification by the SEC or the courts.
The Fund Analyzer helps you sort through and compare more than 30,000 mutual funds, exchange-traded funds, exchange-traded notes, and money market funds.
Before you consider investing in a microcap company, arm yourself first with information. This Guide tells you about microcap stocks, how to find information, what “red flags” to consider, and where to turn if you run into trouble.
FINRA and EDGAR are excellent tools that every investor should employ. However, they also have significant limitations that you must be aware of.
As detailed earlier, EDGAR is an excellent resource for publicly-traded companies. However, like BrokerCheck, it does not contain information about OTC companies. This means you won’t find information on anyone who either is not required to file with the SEC or has not filed with the SEC despite being required to do so. This is why EDGAR should be your first stop, but never your last.
We provide further guidance on researching OTC companies in the next section of the course.
In addition to having the same limitations as EDGAR, FINRA is a private corporation that acts as a self-regulatory organization (SRO), previously known as the National Association of Securities Dealers, Inc. (NASD.)
Yes, you read that correctly. FINRA self-regulates (i.e. brokers regulating brokers), so as an investor you must be aware of this fact.
FINRA is a non-governmental organization that regulates member brokerage firms and exchange markets. The US Securities and Exchange Commission (SEC) is the government agency that acts as the ultimate regulator of the securities industry, including FINRA.
The information on BrokerCheck is largely self-reported and negative disclosure events may be missing or have been expunged from a broker’s record. The Wall Street Journal reported that more than 1,600 stockbrokers have records that failed to disclose bankruptcy filings, criminal charges or other red flags in violation of regulations.
Alarmingly, as reported by CNBC, the Public Investors Arbitration Bar Association, a lawyers’ group, found that brokers who asked arbitrators to recommend expungement got approval in 96.9% of cases that were settled from May 18, 2009 to Dec. 31, 2011.
As an investor, you should maintain a healthy skepticism about the the effectiveness of self-regulation.
While FINRA BrokerCheck should be your first stop for information, you should also consider consulting your state securities regulator, local consumer and investment groups, or others who have established business relationships with a particular broker or investment adviser representative.
Despite its shortcomings, BrokerCheck is still a resource that is available and should be used. Knowing what you know, you should read between the lines. Any and all red flags should carry significant weight.
One type of investment is particularly challenging to perform due diligence on because the lack of regulation renders tools like EDGAR and FINRA impotent.
Over-the-counter markets (also known as “OTC markets” or “Pink Sheets”) are marketplaces for buying and selling securities issued by smaller companies. Generally, these securities are not usually heavily traded and they have limited liquidity. Transactions are conducted directly between the buyer and the seller. Regularly, they are valued at less than a dollar, hence the name “penny stocks.”
OTC markets are subject to little if any oversight by regulatory authorities, representing a high risk for investors.
As a result, OTC markets are prime places for promoting securities and for schemes like the classic pump-and-dump.
Line chart with the following items: SCAMMER SENDS TO INVESTOR: 2, LOOKS LIKE A GOOD BUY: 20, RAMPING UP PROMOTION: 40, I’LL TELL MY FRIENDS: 68, SCAMMER TAKES PROFITS: 82, BACK TO REALITY:
The scam artists sell off their holdings and make a huge profit (the “dump”).
Your investment deflates, rendering it practically worthless. No one wants your securities. In other words, “You lose.”
In order to invest successfully in OTC stocks, you must know more than the name, ticker, and current price. By drilling a little deeper into the company, you can gain a clear picture of the operational strength of a business, understand its sector and strategies, while discovering patterns and profit in the charts.
Refer to the following resources for your OTC analysis, or call professionals for assistance:
SEC Over-the-Counter Market
https://www.sec.gov/divisions/marketreg/mrotc.shtml
Caveat Emptor Policy
https://www.otcmarkets.com/learn/caveat-emptor
FINRA / SEC OTC Rules
https://www.otcmarkets.com/learn/finra-sec-rules
Investor Protection
https://www.otcmarkets.com/learn/investor-protection
Prohibited Service Providers
https://www.otcmarkets.com/learn/prohibited-service-providers
Secretary of State Search (site provides links to all states)
http://www.coordinatedlegal.com/SecretaryOfState.html
Process of Listing On the OTC
An additional area for due diligence that is difficult using SEC and FINRA tools involves real estate.
In order to perform due diligence in this area, it is vital that investors understand the different types of real estate and the different levels of regulation to which they are subject.
Who regulates real estate? Per Washington Post of 2/1/19, “An extensive array of federal, state, county and municipal regulations — variously interpreted and enforced by regulatory officials — govern urban planning, land and infrastructure development, and building construction.”
The scope of real estate fraud, then, could occur anywhere in the world of real estate regulated by many government levels.
As for prosecution, in California, for example, real estate fraud is a category of California criminal fraud, and many are prosecuted under Penal Code 487 PC, California’s grand theft laws: For example, mortgages on real estate (“mortgage fraud”); foreclosures on homes or other real estate (“foreclosure fraud”); rental property (through the crime of “rent skimming”), deeds to real estate; and certain forms of property “flipping.” Specific California real estate forms of fraud are prosecuted under specific California real estate fraud laws: Foreclosure fraud (Civil Code 2945.4), rent skimming (Civil Code 890), and forging real estate deeds (Penal Code 115 PC.)
Real estate frauds result from various investment fraudulent real estate transactions and/or schemes. The real estate investments considered here are:
The promise of earning quick money through investments related to real estate continues to lure investors. Washington State Department of Financial Institutions identifies two of the most popular investment pitches (or lip service) as those that involve so-called “hard-money lending” and “property flipping.”
In hard-money lending, real estate investments are financed in any way other than those offered by traditional banks. Investors are tempted by the opportunity to earn greater rates of return by participating on a hard-money loan despite the potential risks of miscommunication, such as the borrower’s credit, the expected stability of income from the investment, or time constraints.
In property flipping, the scammer(s) may use their money or investor borrowed funds to purchase a distressed property, refurbish it then sell it for a profit. A scammer may, for example, defraud potential investors in the flip by misrepresenting the value of the underlying property or the expected profit potential on the flip. Scammers may also misappropriate borrowed or invested funds or seek to use unwitting investors as “straw buyers” with outside banks or mortgage lenders, leveraging investors’ names and credit scores to facilitate their scams.
According to Mashvisor, an online owner/contributor of informative real estate analytics, the most common real estate scams are loan modification scams (mentioned above), rental scams (scammers replace or forward the legitimate listings contact information with their own and then ask for the payment to be sent to them), seminar scams (mentioned above) and title scams (using false documents pretend to be the homeowner.)
To minimize the risk of being defrauded in real estate investments, the investor is advised to not overlook the basics, such as knowledge base learning in real estate (RE), jargon used, financing, budgeting, what to look for for a type of RE area – stocks, REITS, limited partnerships, home-buying, transactions involved, etc. and as much information you can get on the investment being marketed. Acquire as much knowledge as you can through active networking/socializing from the RE pundits, realtors of that location or people in the RE industry, the RE outlook in the area being pitched, the current consensus of that area marketability, transaction trends, industry trends, etc.
When it comes to due diligence on real estate investments, it is always wise to seek additional professional guidance.
The IFPB is not the only authority advising you on your due diligence practice, as you’ll see in the video below from the U.S. Securities and Exchange Commission.
Following the video, we’ve curated several SEC resources for your reference.
Prepare and protect yourself: This publication will help you to recognize the tell-tale signs of fraud and provides tips for avoiding investment scams.
http://www.sec.gov/investor/pubs/avoidfraud.htm
Information Matters: This publication describes the information you should review before you invest, provides tips on how to find information about companies, and lists several “red flags” to avoid.
http://www.sec.gov/answers/infomatters.htm
Fake Seals and Phony Numbers: How Fraudsters Try to Look Legit. Some fraudsters mix truth with fiction to make their lies more believable. Learn how to protect yourself against deceptive tactics with this publication.
http://www.sec.gov/investor/pubs/fakeseals.htm
Mini-Tender Offers Tips for Investors: Mini-Tender offers typically do not provide the same disclosure and procedural protections that larger traditional offers provide. This offers for less than five percent of a company’s stock have been increasingly used to catch investors off guard.
http://www.sec.gov/investor/pubs/minitend.htm
Microcap Stock: A Guide for Investors: Information about “microcap stocks”-low priced stocks issued by the smallest companies may be difficult to find. When reliable information is scarce, fraudsters can easily spread false information about microcap companies, making profits while creating losses for unsuspecting investors.
http://www.sec.gov/investor/pubs/microcapstock.htm
Stock Market Fraud “Survivor” Checklist: This publication lists the steps for you to follow to avoid stock market fraud.
http://www.sec.gov/investor/pubs/fraudsurvivor.htm
“Pro Forma” Financial Information: Tips for Investors. It is important for investors to know that “pro forma” information is not prepared in accordance with the standards applied to financial statements filed with the SEC. In addition, following the passage of the Sarbanes-Oxley Act of 2002, the SEC adopted additional disclosure requirements for public companies releasing “pro forma” financial data.
http://www.sec.gov/investor/pubs/proforma08-11.htm
View More Materials on Financial Statements:
http://www.sec.gov/investor/pubs_subject.shtml#fstatements
Analyzing Analyst Recommendations: This publication will help you evaluate research reports and recommendations that analyst prepare. As a general matter, investors should not rely solely on an analyst’s recommendation when deciding whether to buy, hold, or sell a stock.
http://www.sec.gov/investor/pubs/analysts.htm
Cold Calling: Your Broker must follow the rules stated in this brochure when he or she makes an unsolicited call to your home. You will also find information indicating your legal rights, how to deal with colds calls, how to stop them, and how to evaluate any investment opportunity that comes your way over the telephone.
http://www.sec.gov/investor/pubs/coldcall.htm
Protect Your Money: Check Out Brokers and Advisers. Before you invest, make sure your brokers, investment advisers, and investment advisers’ representatives are licensed to sell securities. This brochure details how you can determine the validity of your broker’s credentials, whether your broker has had any problems, and more.
http://www.sec.gov/investor/brokers.htm
View More Materials on Brokers
http://www.sec.gov/investor/pubs_subject.shtml#brokers
View More Materials on Advisers
http://www.sec.gov/investor/pubs_subject.shtml#invad
Affinity Fraud: How to Avoid Investment Scams That Target Groups. Learn how to identify and avoid investment scams that prey upon members of identifiable groups, such as religious or ethnic communities, the elderly, or professional groups.
http://www.sec.gov/investor/pubs/affinity.htm
Broken Promises: Promissory Note Fraud. While promissory notes can be legitimate investments, those that are marketed broadly to individual investors often turn out to be scams.
http://www.sec.gov/investor/pubs/promise.htm
Pump & Dump Con: Tips for Avoiding Stock Scams on the Internet. Take time to learn about one of the most common Internet frauds: which is the classic “pump and dump” scheme.
http://www.sec.gov/investor/pubs/pump.htm
Internet Fraud: How to Avoid Internet Investment Scams. This publication will tell you how to spot different types of Internet fraud, what the SEC is doing to fight Internet investment scams, and how to use the Internet to invest wisely.
http://www.sec.gov/investor/pubs/cyberfraud.htm
SEC trading suspensions:http://www.sec.gov/litigation/suspensions.shtml
SEC press releases:http://www.sec.gov/news/press.shtml
SEC administration proceedings:http://www.sec.gov/litigation/admin.shtml
SEC litigation releases:http://www.sec.gov/litigation/litreleases.shtml
Most recent SEC filings:
http://www.sec.gov/cgi-bin/browse-edgar?company=&CIK=&type=&owner=exclude&count=40&action=getcurrent
Need a report? Call (800) 390-0023
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Our team researches the transparency of the investment offering by performing a series of background checks on the sponsor. We also undertake a comprehensive financial analysis that compares the data in the investment offering to verifiable market data that is available to us through industry-leading software.
Never! The reports generated by the IRS are for the benefit of our customers and are meant as a tool to aid in decision making.
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