Due Diligence Revisited

The Appeal Board recently ruled on a determination by the FAIS Ombud on a complaint regarding an investment in the ill-fated Bluezone property syndication.

Last week we commented on the observation by the Board concerning the possibility that the Ombud’s judgment could be affected by the convenience of hindsight, referring to the fact that, at the time of considering the complaint, it was already known that the investment was a Ponzi scheme. The adviser did not have that insight at the time of making the recommendation.

25 The Ombud held that the appellants had failed to conduct a due diligence in this regard and said that if they had they would have established that Bluezone, in 2005, was not licenced to market this product and that the appellants were in this regard negligent. A further consequence of her finding would have been that the provision of the particular advice would have been illegal and not only negligent.

26 It is a pity that the Ombud did not attach the necessary documentation to support such a serious allegation. We called during the hearing for the then current authority of Bluezone and it appeared that the Ombud had no basis for her finding. Bluezone was authorised to market “Securities and instruments: Shares”.

27 The Ombud thought that the product was “debentures and securitised debt”, something not authorised. A glance at the agreement, to which we shall revert, would have revealed that shares and a loan account were sold. There is no reference to debentures or to the securitisation of any debt anywhere on the record.

The Appeal Board then expands on the thorny issue of due diligence, a duty we are expected to perform without any regulatory guidelines on how to do so.

32 Snyman thought that the product did not pose a risk to the complainant, she said, because she had been assured by the promotors of the scheme and their advertising brochures that the risk was low to moderate, whatever that means.

33 Snyman’s opinion was reinforced by the fact that she believed that the investment was effectively in fixed property and that on an analysis of the lease which would have provided the return “the investors faced absolutely no risk whatsoever in respect of the building other than the usual market risks (i.e. that tenants fail to pay a rental or the total overall economy takes a substantial downturn).”

34 Snyman added that she believed that it was a solid investment and that the complainant would “not expose herself to unduly high risk”. She relied on calculations that according to her indicated clearly that the property owning company and its holding company would be able to meet their commitment to pay the complainant her monthly interest and that there would, in addition, be capital appreciation of the property and, consequently, an appreciation of the investment.

35 Snyman also thought that the product did not pose a risk to the complainant because she thought that the FSB had approved the product. She was mistaken: the FSB does not approve products; it authorises the provision of classes of financial services and products.

With the benefit of hindsight it is quite evident that the adviser was naïve in making the assumptions she did, as outlined above, but one has to bear in mind that this was 10 years ago.

On 18 February 2016, we published an article, Notes on Due Diligence, which contained a simple definition of the process, and a summary of the most basic elements of due diligence.

Due diligence implies a process where a person applies his or her mind as part of an investigation into a person or business prior to entering into a transaction with such a person or business.

Any such investigation must be performed with the reasonable standard of care, skill and expertise that may be expected from a person performing such an investigation.

Whilst the due diligence requirement in the financial services industry appears to apply mainly to investment type business, the requirement actually extends to all product providers, as well as licenced FSPs you do business with.

The article also contains examples of the questions contained in our guidelines to Moonstone Compliance clients on the due diligence process.

Apart from the initial verification requirements there is, importantly, also an obligation to stay abreast of day to day developments at providers you deal with, and keeping clients informed. Had this been done as matters unfolded in most of the major implosions in the past, the outcome for many advisers, too, may have been very different.

The tragedy, of course, is that those responsible for these schemes have by and large not yet been brought to book, and are unlikely to ever have to do so.

Picking the low-hanging fruit may have a semblance of justice prevailing, but that is a mere drop in the ocean of injustice to those whom the regulations are intended to protect.

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