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"Alternative Investments":
Stockbrokers Must Perform Their "Due Diligence"
Before They Invest Your Money
s stockbrokers and other advisers search for investments to beat the current flat market, they are turning to alternative investments such as hedge funds, private equity investments and real estate. But these investments often lack regulation and can be highly risky. Before you invest, insist that your financial adviser perform his requisite "due diligence".
In its Policy of the Board of Governors on Fair Dealing With Customers, the National Association of Securities Dealers (NASD) cautions brokerage firms and brokers that:
As new products are introduced from time to time, it is important that members make every effort to familiarize themselves
with each customer's financial situation, trading experience, and ability to meet the risks involved with such products
and to make every effort to make customers aware of the pertinent information regarding the products.
In fact, a stockbroker cannot recommend an investment unless there is an adequate and reasonable basis for the recommendation. By her recommendation, a broker implies that a reasonable investigation has been made of the investment. One court has stated that, when a broker lacks essential information about an investment, he should disclose this as well as the risks that arise from his lack of information. Under no circumstances can a broker deliberately ignore that which he has a duty to know and recklessly state facts about matters that he is ignorant.
"Alternative investments" present special difficulties because many are not easy to understand and many do not contain readily available information. For example, hedge funds come in all sorts of investment "styles" and do not have the detailed reporting requirements that apply to other investments such as mutual funds. Nonetheless, the complexity of the investment requires that the financial adviser perform more, not less, due diligence before recommending the investment. That is because, in those situations, investors especially will look to their advisers for guidance. Advisers must communicate the risks of an investment.
At a minimum, the adviser must perform some level of examination to ensure that any investment "offering material" not contain any incomplete or inaccurate information. In no event can an adviser blindly rely upon representations by the promoters of alternative investments. The duty is one of reasonable investigation under all of the facts and circumstances. Should an adviser notice a "red flag" or warning signal, she must be all the more suspect of other claims and representations by the promoters.
Likewise, the sophistication of the investor also will affect what the stockbroker needs to discuss with the investor in informing the investor of the investment. Investors who are uneducated or generally unsophisticated with respect to financial matters will require greater information, and brokers must carefully and cautiously explain the potential risks of an investment. Although the risks of certain investments are discussed in a risk disclosure document, which is delivered to the investor, that risk disclosure does not relieve the broker of his duty to fully explain the risks of a particular investment. When dealing with complex investments, this also is true even if the investor is an experienced and sophisticated investor.
There are many alternative investments, and their number is growing. Before you join the crowd, make sure that your broker, and you, understand what alternative you are choosing.
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James J. Eccleston is a securities attorney, representing investors as well as brokers and brokerage firms nationwide in arbitration, litigation and regulatory matters. He is the immediate past co-chair of the Chicago Bar Association's Securities Law Committee, the immediate past chair of its Financial and Investment Services Committee, a registered investment advisor and a licensed securities principal of the National Association of Securities Dealers (NASD). He can be reached at 312-641-2929. The firm's website, www.FinancialCounsel.com, contains global market intelligence, daily financial news, alerts, articles, studies, a calendar of upcoming seminars and events, portfolio "diagnostics" tools and book recommendations.
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