Quick Answer
A red flag is any information, public or discovered during the investigation, that would alert a prudent person to dig deeper. When red flags appear, a firm must do more than rely on management's word, the offering document, or even counsel's due-diligence report. It must investigate further, including any substantial adverse information about the issuer.
A red flag does not have to come from outside the deal. It can surface from the very documents and interviews the investigation itself generates.
What Counts as a Red Flag?
- A red flag is any information a firm encounters, whether publicly available or discovered during the investigation itself, that would alert a prudent person to conduct further inquiry.
- A firm must follow up on any red flag it encounters, and must investigate any substantial adverse information about the issuer.
- Promotional material that is questionable in some way is one example the guidance gives. Promising unusually high returns is the example it names.
What Does a Red Flag Override?
When red flags are present, a firm must do more than rely on management's representations, the disclosure in an offering document, or even a due diligence report prepared by the issuer's counsel.
The Securities and Exchange Commission (SEC) has found that a broker could not justifiably rely on financial statements in a private placement memorandum (PPM) that had been audited and certified by an accountant, because numerous red flags indicated the statements were inaccurate. The broker had an unfulfilled duty to conduct a further, independent investigation of the issuer's financial condition.
The SEC has also found a broker to have acted contrary to just and equitable principles of trade where the PPM failed to disclose both the broker's own consulting relationship with the issuer and the litigation history of the issuer's president and CEO.
Exam Tip: Gotchas
- An audited, certified financial statement is not immune from further investigation. When red flags point the other way, the firm must investigate further regardless of the audit.
- One fact pattern can carry two failures at once: a financial-statement red flag the broker ignored, and an undisclosed conflict of interest (the broker's own consulting relationship with the issuer).
What Red Flags Can Arise From the Issuer Itself?
- An issuer's refusal to provide information the firm needs to meet its investigation duty can itself be a red flag. If the issuer is not forthcoming, or provides information that is non-responsive or out of date, the firm must determine whether sufficient information is otherwise obtainable.
- A PPM is not always a legal requirement, but PPMs are typically used in these offerings. A firm must consider whether the absence of a PPM is itself a red flag for that offering.
Exam Tip: Gotchas
- A missing PPM is not automatically disqualifying, and it is not automatically fine either. The firm has to weigh it as a possible red flag on the facts of that offering.
What Should You Check on Exam Day?
- Treat "audited" and "certified" as facts to weigh, not facts that end the inquiry, whenever the stem also mentions a red flag.
- Remember that a due-diligence report from the issuer's own counsel does not override a red flag either.
- Look for an undisclosed conflict of interest (like a consulting relationship) as its own separate violation, apart from any financial-statement red flag in the same scenario.
- Weigh a missing PPM as a fact-specific red flag question, not as an automatic pass or fail.