On Advice

Alts require due diligence

Thompson saga raises questions about veracity of analysis

By Bruce Kelly

Aug 11, 2013 @ 12:01 am (Updated 9:36 am) EST

Financial advisers must demand first-class due diligence and analysis on the bevy of alternative investments flooding the independent-broker-dealer and registered investment adviser marketplaces.

Indeed, last week's news of fraud allegations against noted real estate investor Tony Thompson — stemming from the sale of alternative note investments — calls into question the quality of due diligence that exists in some parts of the independent representative and adviser industries.

Independent broker-dealers routinely protest that they can't afford to perform their own due diligence on alternative investments such as nontraded real estate investment trusts.

“It's too expensive,” the executives moan. “Those costs will shut down the broker-dealer!”

So to fill that gap, product sponsors commonly pay the due-diligence fee to “third party” lawyers.

Remember that, advisers. The product sponsors, not your broker-dealers, pay for due diligence.

Mixed bag

The due-diligence attorney or law firm writes a report on the illiquid REIT or business development company, and that paper lands on the desk of the broker-dealer's due-diligence officer. He or she may read it or simply drop it in their bottom-right-hand desk drawer to gather dust, and the reps then start selling the high-commission, high-risk product.

As it stands, due-diligence attorneys who work with independent broker-dealers are a smattering of small shops hustling cross-country to meet with product sponsors and broker-dealer clients.

There are some outstanding due-diligence analysts in the industry today who aren't afraid to stand up to sponsors. They don't roll over and write a benign report in order to collect a fee.

But there are still others who don't take the time to do their homework and are all too happy to rubber-stamp new deals.

And in our litigious age, broker-dealers must question who is giving them the thumbs up or thumbs down on a real estate or oil and gas deal that could be a boon to advisers and investors or turn into a complete dud.

Or worse, fraud.

The Financial Industry Regulatory Authority Inc. last month filed a complaint against Mr. Thompson and his broker-dealer, TNP Securities LLC, alleging that he deceived and defrauded investors who bought $50 million in high-yield promissory notes sponsored by another Thompson entity, Thompson National Properties LLC, and used the proceeds to fund related businesses.

The math in the private-placement memorandum for those note program deals was at odds with Finra's findings, according to the complaint.

This is where sharp-eyed due diligence wins the day.

Thompson National Properties began losing millions of dollars in 2009 when it launched the sale of the notes, and its equity was also eroding, according to the Finra complaint.

Thompson National Properties' negative financial performance wasn't disclosed to those note program investors, according to Finra.

“Potential investors, however, saw only the PPM balance sheets that reflected total equity of either $8.5 million or $5 million” for two of the Thompson notes, according to the Finra complaint.

In a perfect world, the due-diligence expert would have said to Mr. Thompson and the staff at TNP Securities: “Hey, your PPM says the company is worth $8.5 million. I'd like to see that backed up with your cash flows, balance sheet or independent valuation.”

Check the balance sheet

If Finra, which has deep financial troubles of its own, can figure out a balance sheet, it would seem that the top due-diligence attorneys and analysts in this industry should be able to, as well. How did the due-diligence analysts who reviewed Mr. Thompson's note programs miss a discrepancy in the net worth of the parent company, Thompson National Properties, of more than $20 million?

At what point do registered reps and independent broker-dealers view due diligence as the substantiation of every product sponsor claim, written or oral?

And at what point does Finra start nailing broker-dealers that sell the alternative investment products for unreasonable due diligence, which Finra clearly outlined in its Notice to Members 10-22?

If Finra's complaint is any indication, more actions that focus on specific alternative investment deals could be in the offing. Advisers and broker-dealers: Get your due-diligence conduct and relationships in order before it is too late.