Due Diligence

A firm wants to begin offering a newly developed structured product to retail customers. What must the principal ensure occurs before the product is approved for sale?

1. A.Rely on the wholesaler's marketing brochure describing the product's featuresWrong. Marketing materials from the product sponsor are not a substitute for the firm's own independent due diligence.
2. B.Conduct the firm's own reasonable due diligence on the product's structure, risks, costs, and appropriate customer profileCorrect. The firm must independently assess the new product before approving it for sale, rather than relying on sponsor-provided materials alone.
3. C.Approve the product automatically if it has already been approved for sale at other firmsWrong. Another firm's approval decision does not substitute for this firm's own due diligence obligation.
4. D.Approve the product as long as it has received a favorable rating from an independent research serviceWrong. A favorable third-party rating does not replace the firm's own due diligence process.

Why: The principal must ensure the firm conducts reasonable due diligence on the new product -- understanding its structure, risks, costs, and the customer profile for which it may be appropriate -- before approving it for sale, rather than approving it based solely on the wholesaler's marketing materials.

A program's offering documents include an opinion of tax counsel on the treatment of the losses the program expects to allocate. What does that opinion establish for a prospective investor?

1. A.That the taxing authority has accepted the treatment the program describesWrong. An opinion is not a ruling and the authority is not bound by it.
2. B.That the program's losses are guaranteed to be deductible by investorsWrong. No opinion can guarantee an outcome that depends on facts and on challenge.
3. C.That investors are protected from penalties if the treatment is disallowedWrong. Protection from penalties is not what an offering-document opinion establishes for investors.
4. D.A reasoned professional view on the treatment, which the reviewer must read for its limitsCorrect. Its strength and its qualifications are themselves material information.

Why: An opinion of tax counsel is a reasoned professional view on how the law should apply to the program as structured; it is not a ruling and it does not bind the taxing authority. Reviewing the opinion, including how strongly it is worded and what it declines to conclude, is one of the items a due diligence investigation is expected to cover. A carefully hedged opinion on the central tax benefit of a program is itself a material piece of information about the risk the investor is taking. Had the program obtained an actual ruling on its treatment, the position would be materially stronger, and the offering documents would say so.

Corbin and Vance outsources its daily trade reconciliation to an outside service provider under a contract making the provider responsible for the accuracy of the work. An examination later establishes that the reconciliations were not performed for several months. Who bears the regulatory responsibility?

1. A.The service provider, because the contract assigned the function and the responsibility along with it.Wrong. A contract can allocate cost and liability between the parties but it cannot move a regulatory obligation off the member.
2. B.Corbin and Vance, because a member may outsource an activity but not its responsibility for complying with the rules that govern it.Correct. The duty to reconcile stays with the firm no matter whom it pays to do the work.
3. C.Both, though the firm's exposure is capped at the fees it paid the provider.Wrong. Nothing limits a member's responsibility to the price of the contract, and treating the fee as a ceiling misdescribes how the obligation operates.
4. D.Corbin and Vance, but only because it failed to obtain an indemnity from the provider.Wrong. An indemnity is a private remedy between the parties and its presence or absence does not change who owes the duty.

Why: A member may hand an operational function to a third party, but the regulatory responsibility attached to that function does not travel with it. The firm remains answerable for compliance, which is why the decision to outsource carries obligations of its own: due diligence on the provider before engagement, and supervision and monitoring afterwards. A contract that shifts financial liability to the provider is a commercial arrangement and settles nothing about who answers to the regulator. The analysis would be identical for any function the firm chose to place outside, from statement production to the maintenance of its books and records.

A firm's due diligence for a new income-focused product relies heavily on its strong historical performance track record, without considering whether the market conditions that produced those historical returns are still representative of the environment the product would be operating in going forward. What is the concern with this analysis?

1. A.There is no concern, since a strong historical track record is the most objective and reliable basis available for evaluating any product's future prospects.Wrong. A track record generated under different conditions is not automatically predictive of future performance.
2. B.A historical track record generated under one set of market conditions doesn't necessarily predict how a product will perform going forward if conditions have meaningfully changed, so due diligence needs to consider whether the environment behind the historical numbers still applies, not just cite the favorable track record on its own.Correct. Due diligence needs to evaluate whether the conditions behind a track record still apply, not just cite favorable history.
3. C.The concern is limited to whether the historical performance figures were calculated using a consistent methodology throughout the period presented.Wrong. Methodological consistency is a narrower, different concern than whether the underlying market conditions still apply.
4. D.The concern is that the product should be rejected outright any time its historical returns were generated under different market conditions than the present.Wrong. This overcorrects into automatic rejection rather than requiring the committee to evaluate the applicability of the historical conditions.

Why: A historical track record generated under one set of market conditions doesn't necessarily predict how a product will perform going forward if conditions have meaningfully changed, so due diligence needs to consider whether the environment behind the historical numbers still applies, not just cite the favorable track record on its own.